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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 1-8962
INTEGRATED INFORMATION SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware 86-0624332
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
2250 West 14th Street, Tempe, Arizona 85281
(Address of principal executive offices, including zip code)
(Registrant's telephone number, including area code): (480) 752-5000
Securities registered pursuant to Section 12(g)
of the Act:
Aggregate market value
of shares held by
Title of each class Shares outstanding as non-affiliates as of
of voting stock of March 21, 2003 March 21, 2003
Common Stock, $0.001 Par Value 3,480,151 $1,317,000(a)
(a) Approximate value computed by reference to the closing price on March 21,
2003.
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in any amendment to this Form 10-K. |_|
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive Proxy Statement relating to its 2003
Annual Meeting of Shareholders are incorporated by reference into Part III
hereof.
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TABLE OF CONTENTS
Page
PART I.......................................................................................... 1
Item 1. Business.............................................................. 1
Item 2. Properties............................................................ 5
Item 3. Legal Proceedings..................................................... 5
Item 4. Submission of Matters to a Vote of Security Holders................... 6
Supplemental Item. ..................................................................
Executive Officers of the Registrant ................................. 6
PART II......................................................................................... 7
Item 5. Market for Registrant's Common Stock and Related
Stockholder Matters................................................... 7
PART III........................................................................................ 9
Item 6. Selected Consolidated Financial Data.................................. 9
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations............................................. 10
Item 7A. Quantitative and Qualitative Disclosures about Market Risk............ 25
Item 8. Financial Statements and Supplementary Data........................... 26
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.................................................. 51
Item 10. Directors and Executive Officers of the Registrant.................... 51
Item 11. Executive Compensation................................................ 51
Item 12. Security Ownership of Certain Beneficial Owners and Management........ 51
Item 13. Certain Relationships and Related Transactions........................ 52
Item 14. Controls and Procedures............................................... 52
PART IV......................................................................................... 52
Item 15. Exhibits, Financial Statements, Financial Statement Schedules, and
Reports on Form 8-K................................................... 52
SIGNATURES...................................................................................... 57
CERTIFICATIONS
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PART I
Item 1. Business
Overview
We are a business and technology consultancy and a leading provider of
secure integrated information solutions. With expertise in network design and
integration, security, software development and business intelligence solutions,
we specialize in securely optimizing, enhancing and extending information
applications and networks to serve employees, partners, customers and suppliers.
Our clients are Fortune 1000 and middle market businesses in a range of
industries, including Financial Services, Transportation, Manufacturing,
Education, Healthcare, Retail, Government, Professional Services and
Tradeshow/Event Services.
Company History
Founded in 1989 by our Chief Executive Officer, we have a fourteen-year
history of delivering technology solutions to clients. We reincorporated in
Delaware in 1999, our principal executive office is located at 2250 West 14th
Street, Tempe, Arizona 85281, and our telephone number is 480-752-5000. We
maintain a website at www.iis.com, but the information on our website is not
part of this annual report.
We opened an offshore development center in 1999 to offer clients
application development services with more competitive pricing and in 2000, we
opened several regional offices in the United States, completed both private and
public capital raising transactions and opened an application management
operations facility in Tempe, Arizona.
As part of our efforts to combat lower overall demand for information
technology (IT) services since the third quarter of 2000, we closed several of
the regional offices in the United States, exited most aspects of the hosting
business, reduced staff in remaining offices, negotiated a financial
restructuring, aggressively cut the basic fixed cost structure of the Company,
continued acquiring like-minded peer consultancies and sharpened our focus on
solution offerings in the network design and integration, security, software
development and business intelligence practices.
Strategy
Our goal is to be the leading provider of secure integrated information
systems solutions to the mid-market. To achieve that goal, we:
o Focus on core competencies;
o Drive core competencies to sustainable competitive advantage;
o Allow our focus to create solutions that add value to the client so
that solutions can be value-priced and generate "win-win"
relationships;
o Offer solutions with repeatable processes and methodologies to drive
customer satisfaction and trust; and
o Offer solutions that clients want to buy and can budget.
In a consolidating market, we will also pursue our goal by continuing to
acquire like-minded peer consultancies. We closed four acquisitions through the
end of 2001, two acquisitions in 2002 and anticipate closing more transactions
in 2003. We believe that the IIS brand and our reputation as a provider of high
quality services, in addition to our commitment to this growth strategy,
positions us as an attractive acquisition partner for many IT consulting
practices.
The acquisition target consultancies ideally have leading competitive
positions in regional and vertical markets, a proven track record of providing
Microsoft-based solutions, a list of premier clients, managers in place who are
capable of leading a regional division for the Company, a work culture and ethic
similar to our own and are owned by consultants who remain active in the
business. We also look to reduce redundant positions, consolidate facilities and
look for other efficiencies throughout the combined operations. Although these
acquisitions are structured to increase our net earnings, acquisitions are risky
and involve many uncertainties. Our transactions may decrease, rather than add
to, net earnings.
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Our acquisition growth strategy creates opportunities for us to extend our
service offerings into new markets quicker than we could through internal
development efforts, demonstrate new services to existing clients and establish
a presence as the number one or two partner position in each region with key
vendors and strategic alliances such as Microsoft and Novell.
Optimizing, Enhancing and Extending Information Applications and Networks
Our consultants are industry specialists, and clients view them as trusted
business advisors. While this helps us determine how to respond to changing
market conditions, it also requires our consultants to demonstrate an ongoing
understanding of clients' businesses and the competitive markets our clients
face. Our clients are able to "do more with less" as a result of our focus on
helping them increase revenue, reduce costs, accelerate time to market and
better serve their customers in secure environments. We offer high
return-on-investment solutions that:
o OPTIMIZE existing computing infrastructure - consolidation,
migration and security solutions. These services help clients lower
the total cost of ownership of their information infrastructure,
with emphasis on improving the infrastructure already in place.
o ENHANCE information infrastructure - business intelligence,
enterprise directory and identity management, systems integration,
application development and network management tools. Once our
clients' existing infrastructure is optimized, we can offer them our
enhancement services - deployment of an enterprise directory
structure for enhanced security and more efficient provisioning,
systems integration for improved business systems, and business
intelligence systems for improved decision making. Our emphasis is
on the integration and improvement of the existing applications
already in place.
o EXTEND information across the value chain - custom software
development, enterprise portals, e-commerce and content management.
Once our client's information infrastructure has been secured and
integrated for productive internal use, we offer solutions that
extend their information systems across their value chain for
commerce, collaboration and self-service with new application
development and deployment.
We offer four primary categories of solutions: Application & Network
Integration Services; Secure Information Systems Services; Business
Intelligence; and Business Strategy Services.
Application & Network Integration
We have built our reputation as an established custom application
developer and systems integrator. These practices remain among our core
strengths. We design, develop and integrate systems that are:
o Innovative;
o Cost-Effective;
o Secure;
o Reliable; and
o Scaleable.
We continue to provide leading edge development and integration in our
security, disaster recovery, software development, business intelligence, and
wireless service offerings. In addition to these services, we also provide a
software developer training curricula.
Secure Information Systems - Secure from Data to Device
We specialize in helping our clients maximize the value of their IT
investments by securing information assets, internally and externally. This is
what we call "Secure from Data to Device." Using industry leading analysis and
monitoring tools, we offer a full range of security assessment and remediation
services to identify and address potential security issues before they become
crises and proactively manage future risks. Our services protect information and
systems from viruses, security holes, sabotage and network outages. IIS Secure
Information Service Areas include:
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o IIS Security On-Ramps(TM) - high impact, fixed price packaged
offerings that assess clients' existing exposure to harmful hacker
attacks. IIS Security On-Ramps are designed primarily to deliver
information to help clients manage risk at a point in time and
include:
o Internet Vulnerability Assessments;
o External Security Assessments;
o Internal Security Assessments;
o Application Security Assessments; and
o Hands-On, Digital Crime Prevention Training.
o IIS Managed Security Services - a set of subscription-based product
offerings. To help clients manage risk on a continuous basis, we
offer 24x7x365 Platinum, Gold and Silver levels of:
o Monitoring;
o Intrusion Detection;
o Reporting and Incident Response; and
o Servers, Firewalls and Intrusion Detection Systems.
o IIS Security Professional Services - customized offerings to secure
operations, including:
o Intensive "Boot Camp" Security Training;
o Security Operational Planning;
o Secure Design Assessments;
o Host Hardening;
o Policy Reviews;
o Business Continuity/Disaster Recovery Planning;
o Remediation; and
o Mentoring for Specific Client Situations.
Business Intelligence
We offer Business Intelligence (BI), Data Warehousing (DW) and Intranet
Migration services which permit clients to build and mine large databases to
make quicker and better business decisions and lower the total cost of ownership
of their information infrastructure. We offer packaged service offerings in the
areas of:
o Migrations to/from SQL Server;
o Existing Data Model Effectiveness;
o Database Consolidation;
o BI Readiness Assessment; and
o BI/DW Quality and Cost Reduction.
Our design and deployment of comprehensive Business Intelligence solutions
in Data Migrations and Consolidations address data acquisition, data
preparation, data loading, operational interfaces, application interfaces,
application logic segmentation, software licensing, post migration maintenance
and support. Our database reviews examine database placement, I/O modeling,
tables, indexes, keys, entity relationships, triggers, stored procedures,
cursors, and operational views to evaluate the effectiveness of the data model.
We also offer services to evaluate the efficiency of existing applications on
SQL Server. Throughout the Business Intelligence services offerings, our focus
is on solutions that allow clients to get the right information, the first time,
when they need it and how they need it.
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Business Strategy
We offer clients access to strategic consultants who translate business
concepts into technology plans. Clients utilize our business strategy
consultants to assess the business and technology impact of a solution. To make
an impact in a client's business, the solution must provide significant
improvements in:
o Operations;
o Revenue;
o Market Share;
o Brand Awareness; or
o Usability.
After our clients and consultants have established a technology plan, our
technology professionals convert the plan into reality. Clients draw on our
creative talent, who are selected for their ability to understand technology and
business.
Clients
Over the years, we have worked with business leaders in a variety of
industries. During 2002, we, including the professionals in our recently added
consultancies, delivered security, business strategy, application development
and integration, network integration and outsourcing services to more than 500
clients, including Honeywell, Rayovac, CUNA Mutual and HP. In 2002, client
engagements tended to be smaller than engagements in 2001 and 2000, and we
diversified our client base through our acquisitions. As a result, customer
concentration, and the risks associated with dependence on a small number of
large customers, has decreased from previous levels. In 2002, no customer
accounted for more than 10% of our revenue. Two clients, American Express and
NCS Pearson, accounted for 22% and 12%, respectively, of our revenues in 2001;
and two clients, American Express and PartsAmerica.com, Inc., accounted for 24%
and 10%, respectively, of our revenues in 2000.
Sales and Marketing
Historically, our strongest revenue stream has been through the repeat
business of key clients. Other than the national service offerings and our
inside sales efforts, we do not use a national-focused sales force. Each IIS
regional division is responsible for generating new business and maintaining
existing relationships to increase revenue. Each regional division General
Manager leads a small direct sales force, which is responsible for direct sales
to clients in that region. The sales force also includes billable senior
professionals and consultants to identify opportunities for repeat business with
existing clients. Our growth through acquisition strategy is also designed to
ensure that the recently acquired consultancies are able to sell more billable
projects to their existing client base by offering existing IIS capabilities,
such as Security and Business Intelligence, in addition to their existing
services.
We also generate new clients through our established vendor partnerships
with key technology leaders such as Microsoft, Intel, Dell, Compaq, IBM and
Novell. Our partners provide training, joint selling, and excellent product
offerings to help us deliver best-of-breed solutions to our clients.
Corporate Culture
Our culture has been built on a foundation of continuous learning,
entrepreneurial spirit and team commitment. These are values shared by our
recent acquisitions. Within all divisions and at all locations, we encourage and
reward entrepreneurial drive and accomplishment. We place high value on
continued education, be it in technology, sales and marketing, or customer
service.
Competition
The landscape of the IT services market has changed recently and will
continue to change. In early 2001, our management team recognized that
consolidation in the market was inevitable, and by mid-year we were able to
participate in gaining key market strongholds through acquisitions. Acquisitions
and development of a pipeline of potential acquisitions continued in 2002. As
long as the business justification remains solid and suitable candidates are
identified, we will continue our acquisition strategy in 2003 to add presence in
regional and vertical markets in order to remain competitive.
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The IT services market is an intensely competitive market and is
characterized by rapid change, both in technology and the level of overall
demand for services. We anticipate that the market will remain very competitive
and competition is likely to increase. We compete with much larger providers,
public and private mid-tier IT providers, specialized e-Business consulting
firms, strategy and management consulting firms, offshore application
development firms, vendor-based services groups, and the IT departments of
clients and potential clients. We believe that the principal competitive factors
in those areas of the IT services markets we serve are return on investment,
enhancing existing networks and extending the benefits of existing networks and
applications, Security and Business Intelligence expertise, overall experience
and reputation, and industry specific knowledge. We also believe that we compete
favorably with respect to these factors.
Intellectual Property Rights
We have developed proprietary methodologies, tools, processes, and
software in connection with delivering our services. We rely on a combination of
trade secret, nondisclosure and other contractual agreements, and copyright and
trademark laws to protect our proprietary rights. Existing trade secret and
copyright laws afford us only limited protection. We typically enter into
confidentiality and non-disclosure agreements with our employees and generally
require that our clients enter into similar agreements. These agreements are
intended to limit access to and distribution of our proprietary information. In
addition, we have entered into non-competition agreements with key employees.
There can be no assurance that the steps we have taken in this regard will be
adequate to deter misappropriation of our proprietary information or that we
will be able to detect unauthorized use and take appropriate steps to enforce
our intellectual property rights.
A portion of our business involves the development of software
applications for specific client engagements. We generally retain ownership of
client-specific software, although our clients often retain co-ownership and
limited rights to use the applications, processes, and intellectual property
developed in connection with client engagements. We sometimes enter into
agreements with our clients which provide for sole ownership by our clients of
our developments with no or limited rights retained by us to utilize these
developments in other client engagements.
Employees
We understand that concepts for a client solution are only as good as the
experts tasked with implementing the technology solution. As a result of our
project work over fourteen years and the recent addition of consultancies, we
have demonstrated experience in deploying cutting-edge technology solutions in
several arenas, including Security and Disaster Recovery, E-Commerce, Wireless
Technologies, Web-Enabled Legacy Systems, Financial Reporting Systems and
Business Intelligence. We encourage ongoing professional development and provide
training opportunities for consultants so that they continue to add new sets of
skills to their existing abilities. As of December 31, 2002, we had 153
employees, of which 105 were billable consultants, 22 were in sales and
marketing and 26 were general and administrative personnel. Most of our
employees are hired on an at-will basis. We believe our relationship with our
employees is good, and none of our employees are represented by a union.
Item 2. Properties
Our headquarters are located in a leased facility in Tempe, Arizona
consisting of approximately 7,500 square feet. This lease expires in January
2005. In addition, we have signed leases for three facilities under various
terms totaling approximately 22,000 square feet for regional office space in
Portland, Oregon, Madison, Wisconsin and Milwaukee, Wisconsin. We also have
signed leases on two facilities totaling approximately 45,000 square feet that
are being sublet to unrelated parties. We have signed leases on two facilities
under various terms totaling approximately 14,700 square feet that we are
currently seeking to sublet or terminate. We consider our facilities to be in
good operating condition and suitable for their intended purposes.
Item 3. Legal Proceedings
During July and August 2001, four purported class action lawsuits were
filed in the United States District Court for the Southern District of New York
against the Company, certain of its current and former officers and directors
(the "Individual Defendants") and the members of the underwriting syndicate
involved in the Company's initial public offering (the "Underwriter
Defendants"). All four lawsuits have been transferred to Judge Scheindlin for
coordination with more than 300 similar cases. The suits generally allege that:
(1) the Underwriter Defendants allocated shares of the Company's initial public
offering to their customers in exchange for higher than standard
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commissions on transactions in other securities; (2) the Underwriter Defendants
allocated shares of the Company's initial public offering to their customers in
exchange for the customers' agreement to purchase additional shares of our
common stock in the after-market at pre-determined prices; (3) the Company and
the Individual Defendants violated section 10(b) of the Securities Exchange Act
of 1934 and/or section 11 of the Securities Act of 1933; and (4) the Individual
Defendants violated section 20 of the Securities Exchange Act of 1934 and/or
section 15 of the Securities Act of 1933. The plaintiffs seek unspecified
compensatory damages and other relief. We have sought indemnification from the
underwriters of its initial public offering. In July 2002, we, as part of the
group of issuers of shares named in the consolidated litigation and the
Individual Defendants, filed a motion to dismiss the consolidated amended
complaints. The Underwriter Defendants filed motions to dismiss as well. Also in
July 2002, the plaintiffs offered to dismiss the Individual Defendants, without
prejudice, in exchange for a Reservation of Rights and Tolling Agreement from
each Individual Defendant. All of the Individual Defendants in our four lawsuits
have entered into such an agreement. On November 1, 2002, Judge Scheindlin heard
oral arguments on the motions to dismiss, and in February 2003, Judge Scheindlin
dismissed the section 10(b) claims against the Company but allowed the
plaintiffs to continue to pursue the remaining claims. We believe that the
claims against the Company are unfounded and without merit and intend to
vigorously defend this matter.
In December 2001, we terminated a lease with MCW Brickyard Commercial,
L.L.C. ("MCW") for new office space at 699 South Mill Avenue in Tempe, Arizona
as a result of MCW's failure to deliver the leased premises in a timely manner
and filed suit against MCW in Superior Court in Maricopa County, Arizona to
recover damages it incurred in preparing to move to the premises and for funds
remaining in a construction escrow account. MCW filed an answer, denying all
liability and alleging that we caused delays in delivery of the leased premises.
During March 2002, MCW filed an amended answer and supplemental counterclaim for
lost rent, lost parking income, lost expense income, commissions and unpaid
construction costs. MCW also sought indemnity for construction costs and its
attorneys' fees and interest. In August 2002, MCW filed a voluntary petition for
reorganization under Chapter 11 of the U.S. Bankruptcy Code, and the state court
litigation was stayed as a result. The Company and MCW signed a settlement
agreement during March 2003, and MCW has submitted the settlement to the
bankruptcy court for approval. If the settlement is not approved, we will
vigorously prosecute our claim against MCW and defend against MCW's
counterclaims, which we believe are without merit.
Additionally, we are, from time to time, party to various legal
proceedings arising in the ordinary course of business. We evaluate such claims
on a case-by-case basis, and our policy is to vigorously contest any such claims
which we believe are without merit.
Item 4. Submission of Matters to a Vote of Security Holders
On December 19, 2002, we held a special meeting of stockholders to seek
approval for a reverse stock split of our common stock. At the meeting,
15,060,508 votes were cast in favor of the reverse split, 140,377 were cast
against the reverse split and there were 7,095 abstentions. We effected a
one-for-five reverse split of our common stock on December 30, 2002.
Supplemental Item. Executive Officers of the Registrant
The following table sets forth the names and positions of all of our
current executive officers.
Name Age Position
James G. Garvey, Jr. 38 President, Chief Executive Officer and Chairman
of the Board of Directors
Donald H. Megrath 41 Senior Vice President, Chief Financial Officer
Kenneth J. Biehl 48 Senior Vice President, Controller, Treasurer
and Assistant Secretary
James G. Garvey, Jr.-- Founded Integrated Information Systems, Inc. in
1989 and has served as our President, Chief Executive Officer, and Chairman of
the Board since inception. Mr. Garvey was graduated Cum Laude with a degree in
Industrial Engineering from Arizona State University and has completed graduate
studies at Arizona State University in computer integrated manufacturing,
software development and database design. He is professionally certified in
Systems Integration by the Institute of Industrial Engineers and has received
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certifications from Microsoft, Lotus and Novell. Mr. Garvey serves on the Dean's
Advisory Counsel for the ASU Engineering College and the Advisory Board for the
ASU Center for Services Marketing. He has also taught an Entrepreneurship Course
for the ASU College of Engineering and Applied Science. In addition, Mr. Garvey
is a member of the Information Technology Services Marketing Association and the
Institute for Industrial Engineers. Mr. Garvey was recognized by the Arizona
Software Association as CEO of the Year in 1999 and by Ernst & Young for
Technology/eBusiness Entrepreneur of the Year in 2000.
Donald H. Megrath -- Mr. Megrath joined the Company as Vice President
Finance and Operations in September 2001 and was promoted to Senior Vice
President and Chief Financial Officer in January 2003. From September 1995
through September 2001, Mr. Megrath held several positions with STEP Technology,
Inc., a regional technology consulting firm based in Portland, Oregon, most
recently, from April 2000 to September 2001, as Chief Financial Officer. Prior
to serving STEP as Chief Financial Officer, he served as Director of Corporate
Services Operations and, prior to that, Vice President Operations, New Media.
Mr. Megrath received a Master of Business Administration from George Fox
University in 1996 and a Bachelor of Arts in Telecommunications from George Fox
University in 1984.
Kenneth J. Biehl -- Mr. Biehl joined our Company as Senior Vice President
and Corporate Controller in March 2002 and was appointed Treasurer and Assistant
Secretary in May 2002. From March 1999 through March 2002, Mr. Biehl was
President of CFO Solutions, a management consulting firm, where he consulted for
and was and engaged as: the Executive Vice President and Chief Financial Officer
of LeapSource, Inc., an internet-based, web-enabled provider of finance and
accounting outsourcing services; the Executive Vice President and Chief
Financial Officer of Advance Biometrics, a high-tech software developer and
manufacturer of biometric solutions for Internet and physical security; and the
Executive Vice President and Chief Financial Officer of DiscoverResorts.com, an
Internet-marketed, international resort rental management and services company.
From March 1996 through March 1999, Mr. Biehl was Vice President and Chief
Financial Officer of Sunstone Hotel Investors, a NYSE real estate investment
trust. From March 1997 to March 1999, Mr. Biehl was Vice President and Corporate
Controller for Starwood Lodging. Mr. Biehl received his B.S. from Brigham Young
University in 1986 and is a Certified Public Accountant. Mr. Biehl is President
of LDS Networking, Inc., a national, nonprofit networking company; Chairman of
the Networking Committee of the Arizona Management Society, which is affiliated
with the Marriott School of Management of Brigham Young University; and Chairman
of the Phoenix Chapter of the Financial Executives Networking Group, a national
association of over 10,000 senior financial executives.
PART II
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters
Our common stock commenced public trading on March 17, 2000 in connection
with our initial public offering. Our common stock will be delisted from The
Nasdaq SmallCap Market on April 10, 2003 and, we believe, will trade on the OTC
Bulletin Board under the symbol "IISX". The following table sets forth the high
and low closing sale prices of our common stock, as reported by The Nasdaq
National Market (through June 5, 2002) and The Nasdaq SmallCap Market (from June
6, 2002 through March 21, 2003), for the periods indicated (adjusted for the
one-for-five reverse stock split effected on December 30, 2002):
Market Price
Low High
Fiscal Year 2001
First Quarter.................................................. $8.30 $3.15
Second Quarter................................................. $7.25 $2.65
Third Quarter.................................................. $7.25 $2.75
Fourth Quarter................................................. $4.80 $1.50
Fiscal Year 2002
First Quarter.................................................. $2.00 $0.25
Second Quarter................................................. $1.75 $0.35
Third Quarter.................................................. $1.40 $0.40
Fourth Quarter................................................. $2.50 $0.55
Fiscal Year 2003
Fiscal Year 2003 First Quarter (through March 21, 2003) ....... $1.80 $1.00
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As of March 21, 2003, there were approximately 200 holders of record of
our common stock and approximately 2,000 beneficial holders of our common stock.
We appealed a delisting notification by Nasdaq during 2002 and, in
September 2002, presented a plan of compliance to a Nasdaq Qualification Panel.
Nasdaq granted us a conditional listing in October 2002, subject to meeting a
series of requirements: filing a proxy statement to seek approval of a reverse
stock split; attaining a closing bid price of at least $1.00 per share on or
before December 31, 2002 and for a minimum of 10 consecutive trading days
immediately thereafter; timely filing a Form 10-Q for the quarter ended
September 30, 2002 - with pro forma adjustments - evidencing shareholders'
equity of $2.5 million or more; demonstrating a market value of publicly held
shares of $1.0 million or more on or before December 17, 2002 and for a minimum
of ten consecutive trading days thereafter and timely filing our Form 10-K for
the fiscal year ending December 31, 2002 evidencing shareholders' equity of $2.5
million or more. We have met all requirements to date, but in March 2003, we
notified Nasdaq that our annual report on Form 10-K would not evidence
stockholders' equity of $2.5 million. As a result, we asked Nasdaq for
additional time to regain compliance with that requirement for continued
listing. Nasdaq did not grant us an extension of time to regain compliance with
the requirement, and, accordingly, the trading of our common stock will, we
believe, move to the OTC Bulletin Board on April 10, 2003. Please see "Factors
that May Affect Future Results and Our Stock Price" for additional information.
Equity Compensation Plan Information
The following table provides information about compensation plans
(including individual compensation arrangements) under which our equity
securities are authorized for issuance to employees or non-employees (such as
directors and consultants), as of December 31, 2002:
Number of
Number of securities remaining
securities to be Weighted-average available for future
issued upon exercise price of issuance under equity
exercise of outstanding compensation plans
outstanding options, options, warrants (excluding securities
Plan Category warrants and rights and rights reflected in column (a))
(a) (b) (c)
Equity compensation plans approved by
security holders:
1997 Long Term Incentive Plan.......... 500,315 2.51 651,585
2000 Employee Stock Purchase Plan...... -- -- 60,688
Equity compensation plans not approved by
security holders (1):
2002 Broad-Based Stock Incentive Plan.. 492,852 2.51 707,148
Total....................................... 993,167 1,419,421
(1) See Note 14 of Notes to Consolidated Financial Statements.
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PART III
Item 6. Selected Consolidated Financial Data
The selected consolidated financial data set forth below should be read in
conjunction with the consolidated financial statements and notes thereto and
Management's Discussion and Analysis of Financial Condition and Results of
Operations included elsewhere in this Annual Report on Form 10-K. The selected
financial data in this section is not intended to replace the consolidated
financial statements. The balance sheet data as of December 31, 2002 and
statement of operations data for the year then ended has been derived from our
audited consolidated financial statements and the notes thereto included
elsewhere in this Annual Report on Form 10-K, which has been audited by Hein +
Associates LLP, independent certified public accountants. The balance sheet data
as of December 31, 2001 and statement of operations data for each of the two
years ended December 31, 2001 have been derived from our audited consolidated
financial statements and the notes thereto included elsewhere in this Annual
Report on Form 10-K, which have been audited by KPMG LLP, independent certified
public accountants. The balance sheet data as of December 31, 2000, 1999 and
1998 and statement of operations data for the years ended 1999 and 1998 are
derived from our audited historical consolidated financial statements not
included in this Annual Report on Form 10-K.
Years Ended December 31,
-------------------------------------------------------------
2002 2001 2000 1999 1998
--------- --------- --------- --------- ---------
(In thousands, except per share data)
Statements of Operations Data:
Revenues ............................................. $ 23,250 $ 31,252 $ 54,290 $ 21,205 $ 7,616
Cost of revenues ..................................... 17,452 29,052 34,542 11,347 4,256
Other charges ........................................ -- 2,162 -- -- --
--------- --------- --------- --------- ---------
Gross profit ................................ 5,798 38 19,748 9,858 3,360
--------- --------- --------- --------- ---------
Operating expenses:
Selling and marketing ............................ 3,452 5,620 8,278 2,918 1,276
General and administrative ....................... 12,866 29,694 39,279 8,110 3,067
Asset impairments, restructuring charges and other (2,316) 14,882 -- -- --
--------- --------- --------- --------- ---------
Total operating expenses .................... 14,002 50,196 47,557 11,028 4,343
--------- --------- --------- --------- ---------
Loss from operations ................................. (8,204) (50,158) (27,809) (1,170) (983)
Interest and other income (expense), net ............. (423) 763 2,381 (237) (212)
Provision (benefit) for income taxes ................. -- -- -- (18) 18
--------- --------- --------- --------- ---------
Net loss before preferred stock dividends
and change in accounting principle ........ (8,627) (49,395) (25,428) (1,389) (1,213)
Cumulative effect of a change in accounting principle (3,187) -- -- -- --
Cumulative dividend on preferred stock ............... -- -- -- (246) --
--------- --------- --------- --------- ---------
Net loss attributable to common stockholders $(11,814) $(49,395) $(25,428) $ (1,635) $(1,213)
========= ========= ========= ========= =========
Basic and diluted earnings (loss) per common share ...... $ (3.54) $ (13.57) $ (6.59) $ (.75) $ (.60)
========= ========= ========= ========= =========
Weighted average common shares outstanding:
Basic ............................................ 3,342 3,641 3,860 2,166 2,055
========= ========= ========= ========= =========
Diluted .......................................... 3,342 3,641 3,860 2,166 2,055
========= ========= ========= ========= =========
Balance Sheets Data:
Cash and cash equivalents ............................ $ 1,145 $ 5,235 $ 46,541 $ 863 $ 392
Working capital (deficit) ............................ (2,788) 293 45,540 662 16
Total assets ......................................... 13,280 24,379 81,324 12,118 3,495
Long-term debt and capital lease obligations, less
current installments ............................. 4,497 902 3,909 1,825 1,032
Convertible preferred stock .......................... -- -- -- 4,882 --
Total stockholders' equity (deficiency) .............. 601 11,998 66,150 (704) (56)
9
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Forward-Looking Statements
The following discussion contains forward-looking statements based on
current expectations, and we assume no obligation to update these statements.
Because actual results may differ materially from expectations, we caution
readers not to place undue reliance on these statements. These statements are
based on our estimates, projections, beliefs, and assumptions, and are not
guarantees of future performance. A number of factors could cause future results
to differ materially from historical results, or from results or outcomes
currently expected or sought by us. These factors include: the loss of one or
more of our significant clients; an inability to increase our market share;
difficulties in maintaining our technology alliances; a reduced demand for
Internet services, and a continued downturn in economic conditions.
These factors and the other matters discussed below under the heading
"Factors that May Affect Future Results and Our Stock Price" may cause future
results to differ materially from historical results, or from results or
outcomes we currently expect or seek.
Overview
Since the third quarter of 2000, the market for IT services has changed
dramatically and the demand has declined significantly. As part of our effort to
adjust our structure to better address the general economic business climate and
the slowdown in the IT professional services market, we have closed
underperforming or vacant regional offices, reduced staff in remaining offices,
recorded material charges related to underutilized data center facility computer
equipment and leasehold improvements and developed and began implementing an
aggressive growth strategy through acquiring like-minded peer consultancies. We
completed four such acquisitions in 2001, two such transactions in 2002 and
anticipate additional, similar transactions, in future periods.
We have operated at a loss for each of the last four years with the
exception of the third and fourth quarters of the current year. The losses,
combined with the current market for IT services, have raised concern about our
liquidity and continued operations. We continue to reduce our operating expenses
in order to improve cash flow from operations. During 2002, we were in default
of certain operating and capital lease provisions for failure to make timely
payment, had received several default notices during 2002 and had been named in
a number of related lawsuits. In May 2002, we implemented a financial
restructuring plan designed to settle obligations for vacated facilities, excess
equipment leases and accounts payable related to those facilities and types of
services we were no longer offering to clients in a manner which would achieve
the highest possible recoveries for all creditors and stockholders consistent
with our ability to pay and to continue our operations. In October 2002, we
completed a restructuring which satisfied the obligations for the related real
estate and equipment leases and for certain trade payables for less than their
recorded value. We agreed to pay $2.0 million in cash at the close of the
restructuring and $1.2 million in periodic payments over the next five years
satisfying $2.9 million of recorded accounts payable and accrued expenses, $3.1
million of capital lease obligations and $229,000 of other non-current
liabilities. As a result of the restructuring, a total of approximately $23.0
million of current and future contractual obligations were satisfied. We funded
the restructuring by selling all of our current accounts receivable, totaling
$2.5 million, through a new bank credit facility at a discount of 1.95%, which
left us the ability to sell up to $1.7 million more in current accounts
receivable under the same arrangement. To obtain the financing, we pledged
substantially all of our assets to the bank and we gave the bank a warrant to
purchase 60,000 shares of our common stock at $5.00 per share. Additionally, the
Company's key-man life insurance policy of $5,000,000 was assigned to the bank.
Our Chief Executive Officer gave a $1.0 million personal guaranty to the bank as
credit support, and, in consideration of his guaranty, we have agreed to make
quarterly payments to him at an annual rate of 3% of the average outstanding
balance under the facility and to issue him, quarterly, warrants to acquire
4,000 shares of our common stock for each $1.0 million in average outstanding
balance under the facility during the quarter. The warrants will have an
exercise price of $5.00 per share and will remain exercisable as long as any
amount is guaranteed and for a period of one year thereafter, but for not less
than five years from issuance.
During March and April 2003, we obtained additional credit from our lender
for working capital purposes. The bank has loaned us an additional $500,000,
which was added to the existing note, deferred principal payments under the note
for a year, extended a one-year $1.0 million revolving line of credit and
allowed us to retain a greater amount of proceeds from assets sales, with excess
proceeds to be applied against the note. To obtain this financing, we cancelled
the warrant given in October 2002 and gave the bank a warrant for 300,000 shares
at market price and reaffirmed the security interests previously given and the
assignment of the key-man life insurance. Additionally, our Chief Executive
Officer gave a limited guaranty of $1.0 million for amounts drawn
10
under the revolving line of credit. In February and April 2003, we sold 100,000
shares of preferred stock to an officer and director for total proceeds of $1.0
million. Although no assurances can be given, we believe that the capital and
financing arrangements received subsequent to December 31, 2002 and the
restructuring accomplished in 2002 and 2003 will allow the company to continue
as a going concern. The remaining unused balance on the credit facility of $1.4
million is available to fund future acquisitions and to support working capital
needs; however, availability is dependent upon our ability to generate
additional revenues and increase our accounts receivable base. Accordingly,
notwithstanding the restructuring, if we are unable to raise additional capital,
increase revenues and significantly further reduce operating losses, our
business activities may be significantly curtailed.
We derive our revenues primarily from the delivery of professional
services. We offer our services to clients under time and materials contracts or
under fixed fee contracts. For time and material projects, we recognize revenues
based on the number of hours worked by consultants at a rate per hour agreed
upon with our clients. We recognize revenues from fixed-price contracts on a
percentage-of-completion method based on project hours worked. The percentage of
our revenues from fixed-price contracts was approximately 27% in 2002, 14% in
2001 and 5% in 2000. We provide our application outsourcing services for a
minimum monthly fee and charge extra fees for services that exceed agreed-upon
parameters. Revenues from these services are recognized as services are
provided. Revenues for services rendered are not recognized until collectibility
is reasonably assured.
Our cost of revenues consists primarily of employee compensation, outside
consulting services and benefits. Selling and marketing expenses consist
primarily of compensation and benefits. General and administrative expenses
consist primarily of compensation and benefits for our executive management and
our finance, administration, legal, information technology, and human resources
personnel. General and administrative expenses also include research and
development expense, depreciation, bad debt expense and operating expenses such
as rent, insurance, telephones, office supplies, travel, outside professional
services, training, and facilities costs.
We have historically derived and believe that we may continue to derive a
significant portion of our revenues from a limited number of clients who may
change from period to period (see related discussion below in "Results of
Operations"). Any cancellation, deferral, or significant reduction in work
performed for our principal clients could harm our business and cause our
operating results to fluctuate significantly from period to period. While the
Company's overall reliance on a small number of clients has decreased, during
the year ended December 31, 2002, revenues from our five largest clients
represented, when added together, approximately 26.2% of revenues compared with
51.7% of revenues in 2001. The revenues from each of these clients declined
significantly, starting in the third quarter of 2002, due to the completion of
current engagements.
We incurred a net loss in each of the last five years as a result of
decreases in revenues (after 2000), investments in infrastructure, and increases
in operating expenses and, more recently, as a result of not timely decreasing
operating expenses. Our quarterly revenue, cost of revenues, and operating
results have varied in the past due to fluctuations in the utilization of
project personnel and are likely to vary significantly in the future. Therefore,
we believe that period-to-period comparisons of our operating results may not be
indicative of future performance and should not necessarily be relied upon.
Recent Acquisitions
As part of our effort to adjust our structure to better address a rapidly
changing and declining IT services market, we developed and began implementing
an aggressive growth strategy through acquiring like-minded peer consultancies.
The acquisition target companies ideally have leading competitive positions in
regional and vertical markets, a proven track record of providing
Microsoft-based solutions, a booked backlog of project work for premier clients,
managers in place who are capable of leading a regional division for the
Company, a working culture and ethic similar to our own and are owned by
consultants who remain active in the business.
On August 20, 2001, the Company completed a series of transactions with K2
Digital, Inc. ("K2"), a publicly held digital services firm based in New York
City. In that transaction, 24 management and consulting employees of K2 were
hired, certain related fixed assets were acquired and the leased office space of
K2 in New York City was assumed. The total purchase price consisted of cash
payments of $544,000 for certain K2 assets and $709,000 for the assumption of
liabilities. In the purchase price allocation, $927,000 was recorded as
goodwill. Due to continuing weak economic conditions subsequent to September 11,
2001, generally weak demand for IT services and other factors in the New York
market, management closed the New York K2 operations in July 2002.
11
On September 28, 2001, a similar series of transactions were completed
with STEP Technology, Inc. ("STEP"), a Portland, Oregon-based information
technology consulting firm. In that transaction, 54 management and consulting
personnel of STEP were hired, certain related assets were acquired and a portion
of STEP's office space in Portland was assumed. The total purchase price
consisted of cash payments of $1,140,000 for certain STEP assets and $1,041,000
for the assumption of liabilities. In the purchase price allocation, $1,433,000
was recorded as goodwill. In addition to the cash consideration, under the
purchase agreement, if in 2002, 2003, and 2004 annual earnings from STEP
operations are positive, STEP is entitled to additional consideration from this
transaction based on a percentage of the revenues generated and limited to an
agreed upon percentage of earnings.
On October 31, 2001, a series of transactions were completed with
INTEFLUX, Inc. ("INTEFLUX"), a privately-owned international technology
consulting firm based in Phoenix, Arizona, with operations in New York City and
London, England. In that transaction, 19 management and consulting employees of
INTEFLUX were hired, certain related assets were acquired and INTEFLUX's office
space in Phoenix and London was assumed. The total purchase price consisted of
cash payments of $50,000 and the issuance of common stock totaling $187,000 for
certain INTEFLUX assets and $319,000 for the assumption of liabilities. In the
purchase price allocation, $346,000 was recorded as goodwill. In addition to the
cash and common stock consideration, under the purchase agreement, if in 2002,
2003 and 2004 annual earnings from INTEFLUX operations are positive, INTEFLUX is
entitled additional consideration from this transaction based on a percentage of
the revenues generated and limited to an agreed upon percentage of earnings or
dollar amount.
On November 16, 2001, a series of transactions were completed with
Winfield Allen, Inc. ("Winfield Allen"), a Denver, Colorado-based information
technology consulting firm. In that transaction, 24 management and consulting
personnel of Winfield Allen were hired, certain related assets were acquired and
Winfield Allen's leased office space in Colorado was assumed. The total purchase
price consisted of cash payments of $84,000 and the issuance of common stock
totaling $136,000 for certain Winfield Allen assets, the assumption of a note
payable for $103,000 and $173,000 for the assumption of liabilities. In the
purchase price allocation, $358,000 was recorded as goodwill. In addition to the
cash and common stock consideration, under the purchase agreement, if in 2002,
2003, and 2004 annual earnings from Winfield Allen operations are positive,
Winfield Allen is entitled to additional consideration from this transaction
based on a percentage of the revenues generated and limited to an agreed upon
percentage of earnings or dollar amount. No amount is expected to be paid under
this provision.
During 2002, in connection with the effective date of Statement of
Financial Accounting Standard No. 142, "Goodwill and Other Intangible Assets,"
we were required to assess the impairment of our recorded goodwill relating to
the above acquisitions. As discussed in Note 17 of the Notes to Consolidated
Financial Statements, all of the goodwill recorded through December 31, 2001
totaling $3,064,000 and related acquisition costs of $123,000 were written off
as a non-cash, cumulative effect of a change in accounting principle.
On January 25, 2002, we completed a transaction with Goliath Networks,
Inc. ("Goliath"), a Madison, Wisconsin-based information technology consultancy.
In that transaction, 81 management and consulting personnel of Goliath were
hired, certain related assets acquired and the lease agreements for office space
of Goliath in Madison and Milwaukee, Wisconsin were assumed. In the purchase
price allocation, $4,829,000 was recorded as goodwill and intangibles. The
transaction was paid for with a combination of cash payments totaling $400,000,
the issuance of a note payable for $4,750,000 to a bank (see Note 9 of the Notes
to Consolidated Financial Statements) and the assumption of $209,000 of
liabilities.
On November 15, 2002, we completed a transaction with Cunningham
Technology Group. ("CTG"), a privately-owned technology consulting firm based in
Phoenix, Arizona. In that transaction, 17 management and consulting personnel of
CTG were hired, certain related assets acquired and certain lease agreements for
computers were assumed. In the purchase price allocation, $326,000 was recorded
as goodwill and intangibles. The transaction was paid for with a combination of
cash payments totaling $374,000, the issuance of 150,000 shares of common stock
(valued at $338,000) and the assumption of $131,000 of liabilities. CTG is
entitled to additional consideration from this transaction based on a percentage
of the revenues generated and limited to an agreed upon percentage of earnings
or dollar amount.
As part of these acquisitions, intangible assets totaling $682,000 were
acquired consisting of non-compete agreements of $325,000 and employee
agreements of $357,000. The non-compete intangible assets will be amortized over
their contractual lives, which are generally five years. The employee
agreements' intangible assets were amortized over their contractual lives, which
were less than one year. The goodwill recorded for these four acquisitions
totals $3,187,000, which includes acquisition related costs of $123,000. It is
estimated that most of
12
this goodwill will be deductible for tax purposes, subject to the utilization of
the Company's net operating losses. See Note 11 of the Notes to the Consolidated
Financial Statements.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis we evaluate our estimates, including those
related to intangible assets, long-term service contracts, bad debts, income
taxes, restructuring, and contingencies and litigation. We base our estimates on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.
We believe the following critical accounting policies affect the more
significant judgments and estimates used in the preparation of our consolidated
financial statements. We recognize revenue and profit as work progresses on
long-term, fixed price contracts using the percentage-of-completion method,
which relies on estimates of total expected contract revenue and costs. We
follow this method because reasonably dependable estimates of the revenue and
costs applicable to various stages of a contract can be made. Recognized
revenues and profit are subject to revisions as the contract progresses to
completion. Revisions in profit estimates are charged to income in the period in
which the facts that give rise to the revision become known. We maintain
allowances for doubtful accounts for estimated losses resulting from the
inability of our customers to make required payments. 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. We record
goodwill and other intangible assets from acquisitions. We review the company's
intangible assets on a periodic basis to determine if the fair value supports
the carrying value of goodwill and other intangible assets. Future adverse
changes in market conditions or poor operating results could result in an
inability to recover the carrying value of the investments that may not be
reflected in the current carrying value of the intangible assets, thereby
possibly requiring material impairment charges in the future. The determination
of reporting units needed for the impairment calculation also involves a
significant amount of judgment. We record a valuation allowance to reduce the
Company's deferred tax assets to the amount that is more likely than not to be
realized. In the event we were to determine that the Company would be able to
realize its deferred tax assets in the future in excess of its net recorded
amount, an adjustment to the deferred tax asset would increase income in the
period such determination was made. We recorded accruals for the estimated
future cash expenditures required from closing our vacated offices. The
accruals, through December 31, 2002, include estimates of future rent payments
and settlements until the obligation is canceled. Should actual cash
expenditures differ from our estimates, revisions to the estimated liability for
closing vacated offices would be required. We evaluate the requirement for
future cash expenditures resulting from the Company's contingencies and
litigation. Should the actual results differ from our estimates, revisions to
the estimated liability for contingencies and litigation would be required.
Results of Operations
The following table sets forth selected financial data for the periods
indicated expressed as a percentage of revenues:
Years Ended December 31,
------------------------------
2002 2001 2000
------ ------- ------
Revenues.......................................................... 100.0% 100.0% 100.0%
Cost of revenues.................................................. 75.1 93.0 63.6
Other charges..................................................... -- 6.9 --
------ ------- ------
Gross profit................................................ 24.9 0.1 36.4
------ ------- ------
Operating expenses:
Selling and marketing......................................... 14.8 18.0 15.2
General and administrative.................................... 55.4 95.0 72.4
Asset impairments, restructuring charges and other............ (10.0) 47.6 --
------ ------- ------
Total operating expenses.................................... 60.2 160.6 87.6
------ ------- ------
13
Years Ended December 31,
------------------------------
2002 2001 2000
------ ------- ------
Loss from operations........................................ (35.3) (160.5) (51.2)
Interest and other income (expense), net.......................... (1.8) 2.4 4.4
------ ------- ------
Cumulative effect of a change in accounting principle............. (13.7) -- --
------ ------- ------
Net loss.................................................... (50.8)% (158.1)% (46.8)%
====== ======= ======
Year Ended December 31, 2002 Compared to Year Ended December 31, 2001
Revenues. Revenues decreased 26% to $23.3 million in 2002 from $31.3
million in 2001. Revenues from our largest customer decreased to $1.0 million
compared to $6.7 million in 2001. Declines in billed hours resulted in decreases
totaling approximately $10.0 million in 2002 compared to 2001. Increases in
average hourly bill rates resulted in increases of approximately $2.0 million in
revenues in 2002 compared to 2001.
Cost of Revenues. Cost of revenues decreased 40% to $17.5 million in 2002
from $29.1 million in 2001. As a percentage of revenue, cost of revenues were
75.1% in 2002 compared to 93.0% in 2001, primarily due to a decrease in overall
firm staffing and implementation of hourly and variable pay plans and
depreciation of data center assets in 2002.
Other Charges. During 2001, we recorded a $2.2 million non-cash charge due
to the impairment of inventoried software licenses.
Selling and Marketing Expenses. Selling and marketing expenses decreased
38% to $3.5 million in 2002 from $5.6 million in 2001 and as a percentage of
revenues decreased to 14.8% in 2002 from 18.0% in 2001. Approximately $2.1
million of the decrease in selling and marketing expenses in 2002 was due
primarily to the reduction of dedicated sales and marketing personnel in 2002
compared to 2001.
General and Administrative Expenses. General and administrative expenses
decreased 57% to $12.9 million in 2002 from $29.7 million in 2001 and as a
percentage of revenues decreased to 55.3% in 2002 from 95.0% in 2001. The
decrease in general and administrative expenses in 2002 was primarily due to
management's implementation of its cost reduction plan and are attributable to a
reduction in rent expense of $3.7 million, salary expense of $1.8 million, legal
expense of $1.6 million, depreciation and amortization expense of $1.3 million,
telephone expense of $1.2 million, consulting services of $1.1 million, general
office expense of $918,000, taxes and permits expense of $555,000, travel
expense of $480,000, recruiting expense of $429,000, a net change in the
provision for bad debt expense of $1.7 million and other net cost reductions of
$2.0 million.
Asset Impairments and Restructuring Charges. During 2001, we recorded a
$9.2 million impairment charge related to underutilized data center facility
computer equipment and leasehold improvements and a $5.7 million charge for
expenses incurred in connection with closing and consolidating six office
locations. During 2002, in connection with our restructuring efforts and the
resulting favorable settlement of certain obligations and lease agreements, we
re-evaluated our reserve for closed office locations and recorded a $1.0 million
reduction of the restructuring reserve. We also recorded a gain on the
settlement of payables of $1.2 million relating to these favorable settlement
agreements.
Interest Expense Net. We incurred interest expense, net of interest
income, totaling $0.4 million in 2002 compared to interest income, net of
interest expense of $0.8 million in 2001. The change in 2002 was primarily due
to interest on bank financing used for acquisitions. The change in 2002 was also
due to higher interest income generated in 2001 from invested excess cash.
Year Ended December 31, 2001 Compared to Year Ended December 31, 2000
Revenues. Revenues decreased 42% to $31.3 million in 2001 from $54.3
million in 2000. Revenues from our largest customer decreased to $6.7 million
compared to $13.2 million in 2000. Declines in both billed hours and new
engagements resulted in decreases totaling approximately $17.3 million in 2001
compared to 2000. Declines in average hourly bill rates resulted in decreases of
approximately $3.0 million in revenues in 2001 compared to 2000. We believe that
these declines in revenue reflected general weakening in our industry sector.
During 2001, we did not record $2.7 million of revenue in connection with
services provided to customers where collection was not deemed probable.
14
Cost of Revenues. Cost of revenues decreased 16% to $29.1 million in 2001
from $34.5 million in 2000. As a percentage of revenue, cost of revenues were
93.0% in 2001 compared to 63.6% in 2000, primarily due to lower utilization
rates for project personnel in 2001 compared to 2000 and increased costs
attributable to application outsourcing services.
Other Charges. During 2001, we recorded a $2.2 million non-cash charge due
to the impairment of inventoried software licenses.
Selling and Marketing Expenses. Selling and marketing expenses decreased
33% to $5.6 million in 2001 from $8.3 million in 2000. Approximately $2.1
million of the decrease in selling and marketing expenses in 2001 was due to
reduced advertising and promotional expenses. In addition, approximately $0.6
million was attributable to the reduction of dedicated sales and marketing
personnel in 2001 compared to 2000. As a percentage of revenues, selling and
marketing expenses increased to 18.0% of revenue in 2001 from 15.2% in 2000
primarily as a result of the reduction in revenue.
General and Administrative Expenses. General and administrative expenses
decreased 24% to $29.7 million in 2001 from $39.3 million in 2000. The decrease
in general and administrative expenses in 2001 compared to 2000 was attributable
to approximately $10.9 million in reduced bad debt expense, approximately $1.9
million in reduced depreciation expense, and approximately $0.7 million in
reduced leased equipment costs as compared to 2000. These decreases were
partially offset by an approximately $2.1 million increase in professional fees
and litigation settlements, $1.8 million increase in office rent expenses as a
result of our regional office expansion, and an approximately $0.4 million
increase in telecommunication costs. As a percentage of revenues, general and
administrative expenses increased to 95.0% of revenue in 2001 from 72.4% in 2000
primarily as a result of the reduction in revenue.
Asset Impairments and Restructuring Charges. During 2001, we recorded a
$9.2 million impairment charge related to underutilized data center facility
computer equipment and leasehold improvements and a $5.7 million charge for
expenses incurred in connection with closing and consolidating six office
locations.
Interest Income, Net. Interest income, net of interest expense decreased
to $0.8 million in 2001 compared to $2.4 million in 2000. The decrease in 2001
was due primarily to the use during 2001 of the previously invested proceeds
from both our preferred stock financing in January 2000 and our initial public
offering in March and April 2000.
15
Quarterly Results of Operations
The following table sets forth a summary of our unaudited quarterly
operating results for each of the eight quarters ended December 31, 2002, and
the percentage of our revenues represented by each item in the respective
quarters. This data has been derived from our unaudited interim financial
statements which, in our opinion, have been prepared on substantially the same
basis as the audited consolidated financial statements contained elsewhere in
this Annual Report on Form 10-K and include all normal recurring adjustments
necessary for a fair presentation of the financial information for the periods
presented. These unaudited quarterly results should be read in conjunction with
our audited consolidated financial statements and notes thereto included
elsewhere in this Annual Report on Form 10-K. The operating results in any
quarter are not necessarily indicative of the results that may be expected for a
full year or in any future period.
Quarters Ended
--------------------------------------------------------------------------------------------------
Dec. 31, Sept. 30, June 30, Mar. 31, Dec. 31, Sept 30, June 30, Mar. 31,
2002 2002 2002 2002 2001 2001 2001 2001
--------- ---------- --------- ---------- ---------- ---------- ---------- ----------
(In thousands)
Statement of Operations Data:
Revenues ................ $ 3,363 $ 4,491 $ 7,129 $ 8,267 $ 5,988 $ 6,172 $ 8,655 $ 10,437
Cost of revenues ........ 2,603 3,208 5,409 6,232 5,278 5,814 8,649 9,311
Other charges ........... -- -- -- -- -- -- 2,162 --
------- -------- -------- --------- --------- --------- --------- ---------
Gross profit (loss) . 760 1,283 1,720 2,035 710 358 (2,156) 1,126
Operating expenses:
Selling and marketing 770 912 716 1,054 1,277 1,408 1,484 1,451
General and
administrative .... 1,774 2,200 3,247 5,645 6,156 7,881 7,379 8,278
Asset impairments,
restructuring
charges, and other (2,427) (2,773) 133 2,751 5,691 47 9,144 --
------- -------- -------- --------- --------- --------- --------- ---------
Total operating
expenses .......... 117 339 4,096 9,450 13,124 9,336 18,007 9,729
------- -------- -------- --------- --------- --------- --------- ---------
Income (loss) from
operations ........ 643 944 (2,376) (7,415) (12,414) (8,978) (20,163) (8,603)
Interest and other
income (expense),
net ............... (216) (31) (106) (70) (38) 207 210 384
------- -------- -------- --------- --------- --------- --------- ---------
Net income (loss)
before cumulative
effect of a change
in accounting
principle ......... $ 427 $ 913 $ (2,482) $ (7,485) $ (12,452) $ (8,771) $ (19,953) $ (8,219)
======= ======== ======== ========= ========= ========= ========= =========
As a Percentage of Revenues:
Revenues ................ 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of revenues ........ 77.4 71.4 75.9 75.4 88.1 94.2 99.9 89.2
Other charges ........... -- -- -- -- -- -- 25.0 --
------- -------- -------- --------- --------- --------- --------- ---------
Gross profit (loss) . 22.6 28.6 24.1 24.6 11.9 5.8 (24.9) 10.8
------- -------- -------- --------- --------- --------- --------- ---------
Operating expenses:
Selling and marketing 22.9 20.3 10.0 12.7 21.3 22.8 17.1 13.9
General and
administrative .... 52.8 49.0 45.5 68.3 102.8 127.7 85.3 79.3
Asset impairments,
restructuring
charges, and other (72.2) (61.7) 1.9 33.3 95.1 .8 105.7 --
------- -------- -------- --------- --------- --------- --------- ---------
Total operating
expenses .......... 3.5 7.5 57.4 114.3 219.2 151.3 208.1 93.2
Income (loss) from
operations ........ 19.1 21.0 (33.3) (89.7) (207.3) (145.5) (233.0) (82.4)
Interest and other
income (expense),
net ............... (6.4) (0.7) (1.5) (0.8) (.6) 3.4 2.5 3.7
------- -------- -------- --------- --------- --------- --------- ---------
Net income (loss)
before cumulative
effect of a change
in accounting
principle ......... 12.7% 20.3% (34.8)% (90.5)% (207.9)% (142.1)% (230.5)% (78.7)%
======= ======== ======== ========= ========= ========= ========= =========
Liquidity and Capital Resources
Since inception, we have primarily funded our operations and investments
in property and equipment through cash, capital lease financing arrangements,
bank borrowings, and equity financings. In January 2000, we raised $20.2
million, before expenses of $800,000, through a private placement of Series C
preferred stock to institutional and other accredited investors. In March and
April 2000, we raised an additional $67.5 million (net of underwriting discounts
and other offering expenses) through our initial public offering of 989,000
shares of our common stock.
At December 31, 2002, we had approximately $1.1 million in cash and cash
equivalents and a $2.8 million working capital deficit, as compared to $5.2
million in cash and cash equivalents and $0.3 million of working capital at
December 31, 2001.
Net cash used in operating activities for the years ended December 31,
2002, 2001, and 2000 was $5.6 million, $23.8 million, and $19.9 million,
respectively. Cash used in operating activities in each of these periods
16
was the result of net losses, adjusted for non-cash items related to
depreciation, amortization and asset impairment, and fluctuations in
receivables, unbilled and deferred revenues on contracts, prepaid expenses and
other current assets, and accounts payable and accrued expenses and, in 2002,
cumulative effect of change in accounting principle and gain on settlement of
debt.
Net cash used in investing activities for the years ended December 31,
2002, 2001, and 2000 was $0.7 million, $6.9 million, and $16.9 million,
respectively. Cash used in investing activities in each period consisted
primarily of purchases of computer equipment, furniture and leasehold
improvements. During 2002 and 2001 we invested in acquisitions of assets of
other companies totaling $0.8 and $2.8 million, respectively. During 2000 we
invested approximately $7.0 million, net of leased furniture and equipment, in
our application outsourcing services data center. We also invested in
geographical expansion during 2000.
For 2002, net cash provided by financing activities was $2.2 million,
compared to net cash used in financing activities in 2001 of $10.6 million and
net cash provided by financing activities in 2000 of $82.5 million. During 2002,
we obtained additional bank financing of $2.9 million, repaid capital lease
obligations of approximately $1.0 million and used approximately $0.3 million of
restricted cash. During 2001, we repurchased 990,360 shares of our common stock
for approximately $5.3 million. Our net repayments of capital lease obligations
totaled approximately $4.4 million for the same period. We also allocated $3.5
million to restricted cash of which $2.4 million was used during 2001. During
2000, we obtained approximately $19.4 million, net of expenses, through a
private placement of Series C preferred stock and $67.5 million, net of
expenses, through our initial public offering. We used approximately $4.9
million for repayment of debt and capital lease obligations. In 2002, we also
assumed a note for $4,500,000 in conjunction with an acquisition.
Non-cash investing and financing activities for the years ended December
31, 2002, 2001, and 2000 consisted of new capital lease obligations for property
and equipment of $0.4 million, $0.2 million and $9.3 million, respectively. In
addition, as a result of our acquisitions during 2002 and 2001, we assumed
capital lease obligations totaling $24,000 and $0.2 million and issued common
stock totaling $0.4 million and $0.3 million, respectively. In 2002, we also
assumed a note for $4,750,000 in conjunction with an acquisition.
As of December 31, 2001, we had a master lease agreement to finance up to
$3.0 million of computer equipment with Comerica Leasing Corporation, as
successor to Imperial Bank. The master lease agreement had an implied interest
rate of approximately 10.5%. As of December 31, 2001, approximately $1.0 million
was outstanding under this master lease agreement. The master lease agreement
expired on various dates through June 2002. In June 2001, we deposited $1.0
million into a restricted certificate of deposit account. The funds in this
account served as collateral against various letters of credit totaling $1.0
million. During 2002 and 2001, $0.7 million and $0.3 million of the funds were
drawn down to pay current and future lease obligations. We were in default under
the master lease agreement during 2002 and brought suit against Comerica to
determine our respective rights under the leases and letters of credit. We
settled all outstanding obligations and litigation with Comerica during October
2002 for a payment of $400,000.
A summary of our contractual cash obligations at December 31, 2002
(adjusted for settlements reached subsequent to year end) follows (amounts in
thousands):
Fixed
Settlement Capital Operating
Bank Note Agreements Leases Leases Total
--------- ---------- ------ ------ -----
2003 ......................... $ -- $180 $ 46 $ 755 $ 981
2004 ......................... 282 76 17 639 1,014
2005 ......................... 329 38 -- 433 800
2006 ......................... 4,139 38 -- 305 4,482
2007 ......................... -- 35 -- 167 202
Thereafter ................... -- -- -- -- --
------ ---- ------ ------ ------
$4,750 $367 $ 63 $2,299 $7,479
====== ==== ====== ====== ======
We have incurred significant losses from operations over the past three
years. We have a substantial working capital deficit and an accumulated deficit
of $88,650,000 as of December 31, 2002. We were also in default under the terms
of a factoring agreement with our primary lender on December 31, 2002 and may
have been in technical default on other borrowing arrangements with this lender.
However, all such defaults and
17
potential defaults were waived by the bank. As a result of these and other
factors, there are concerns about the liquidity of the Company at December 31,
2002.
Our continuation is dependent upon our efforts to raise additional
capital, increase revenues, reduce expenses, and ultimately, to achieve
profitable operations. We have reduced our obligations and expenses through
settlements with creditors, landlords and lessors, reduced our work force, and
made substantial reductions to general and administrative expenses throughout
2002 and through the first quarter of 2003.
Subsequent to December 31, 2002, we obtained the following:
o A $500,000 increase to our term loan;
o A $1,000,000 Line of Credit with our primary lender; and
o $1,000,000 of proceeds from the sale of preferred stock to an
officer and director of the Company.
We also reached a new settlement with a primary creditor resulting in the
settlement of $901,000 of obligations recorded at December 31, 2002 for a
one-time payment of $200,000 and the issuance of 100,000 shares of common stock
at $0.95 per share. Furthermore, we have made our cost structure significantly
more variable and we believe we can continue to reduce expenses if it is
required.
While we cannot give any assurances that the above actions will be
sufficient to ultimately alleviate our liquidity concerns, or that additional
borrowings or capital could be obtained under satisfactory terms if they become
required, we do believe these actions will enable us to continue as a going
concern through December 31, 2003.
Recently Issued Accounting Pronouncements
In April 2002, the FASB issued Statement of Financial Accounting Standard
No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections" (SFAS 145), which addresses
financial accounting and reporting for reporting gains and losses from
extinguishment of debt, accounting for intangible assets of motor carriers and
accounting for leases. SFAS 145 requires that gains and losses from the early
extinguishment of debt should not be classified as extraordinary, as previously
required. SFAS 145 also rescinds Statement 44, which was issued to establish
accounting requirements for the effects of transition to the provisions of the
Motor Carrier Act of 1980 (Public Law 96-296, 96th Congress, July 1, 1980).
Those transitions are completed; therefore, Statement 44 is no longer necessary.
Statement 145 also amends Statement 13 to require sale-leaseback accounting for
certain lease modifications that have economic effects that are similar to
sale-leaseback transactions. Statement 145 also makes various technical
corrections to existing pronouncements. Those corrections are not substantive in
nature. The provisions of this statement relating to Statement 4 are applicable
in fiscal years beginning after May 15, 2002. The provisions of this Statement
related to Statement 13 are effective for transactions occurring after May 15,
2002. All other provisions of this Statement are effective for financial
statements issued on or after May 15, 2002. The company adopted the provisions
of SFAS 145 relating to Statement 4 and, consequently, reported the gain from
the settlement of payables in operations. The adoption of the provisions of SFAS
145 relating to Statement 13 did not have a material impact on our consolidated
financial statements.
In June 2002, the FASB issued Statement of Financial Accounting Standards
SFAS No. 146, "Accounting for Exit or Disposal Activities" (SFAS 146). SFAS 146
addresses the recognition, measurement and reporting of costs associated with
exit and disposal activities, including restructuring activities. SFAS 146 also
addresses recognition of certain costs related to terminating a contract that is
not a capital lease, costs to consolidate facilities or relocate employees and
termination of benefits provided to employees that are involuntarily terminated
under the terms of a one-time benefit arrangement that is not an ongoing benefit
arrangement or an individual deferred compensation contract. SFAS 146 is
effective for exit or disposal activities that are initiated after December 31,
2002. We are in the process of evaluating the adoption of SFAS 146 and its
impact on the financial position or results of operations.
In December 2002, the FASB issued Statements of Financial Accounting
Standards No.148, "Accounting for Stock-Based compensation - Transition and
Disclosure - an amendment of FASB Statement 123" (SFAS 123). For entities that
change their accounting for stock-based compensation from the intrinsic method
to the fair value method under SFAS 123, the fair value method is to be applied
prospectively to those awards granted after the beginning of the period of
adoption (the prospective method). The amendment permits two additional
transition
18
methods for adoption of the fair value method. In addition to the prospective
method, the entity can choose to either (i) restate all periods presented
(retroactive restatement method) or (ii) recognize compensation cost from the
beginning of the fiscal year of adoption as if the fair value method had been
used to account for awards (modified prospective method). For fiscal years
beginning December 15, 2003, the prospective method will no longer be allowed.
We currently account for the Company's stock-based compensation using the
intrinsic value method as prescribed by Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" and plan on continuing using this
method to account for stock options, therefore, it does not intend to adopt the
transition requirements as specified in SFAS 148. We have adopted the new SFAS
148 disclosure requirements in these financial statements.
Factors that May Affect Future Results and Our Stock Price
This Annual Report on Form 10-K includes forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Act of 1934. Forward-looking statements give our current expectations
or forecasts of future events. Words such as "expect," "may," "anticipate,"
"intend," "would," "will," "plan," "believe," "estimate," "should," and similar
expressions identify forward-looking statements. Forward-looking statements in
this Form 10-K include express or implied statements concerning our future
revenues, expenditures, capital or other funding requirements, the adequacy of
our current cash and working capital balances to fund our present and planned
operations and financing needs, expansion of and demand for our service
offerings, and the growth of our business and operations, as well as future
economic and other conditions both generally and in our specific geographic and
product and services markets. These statements are based on our estimates,
projections, beliefs, and assumptions and are not guarantees of future
performance. From time to time, we also may provide oral or written
forward-looking statements in other materials we release to the public.
We caution that the following important factors, among others, could cause
our actual results to differ materially from those expressed in forward-looking
statements made by or on behalf of us in filings with the Securities and
Exchange Commission, press releases, communications with investors, and oral
statements. Any of these factors, among others, could also negatively impact our
operating results and financial condition and cause the trading price of our
common stock to decline or fluctuate significantly. We undertake no obligation
to publicly update any forward-looking statements, whether as a result of new
information, future events or otherwise. You are advised, however, to consult
any further disclosures we make in our reports filed with the Securities and
Exchange Commission and in future public statements and press releases.
We have experienced operating losses and may incur operating losses in future
periods, which could cause the price of our common stock to decline further.
We had a net loss of approximately $11.8 million for the year ended
December 31, 2002, a net loss of $49.4 million for the year ended December 31,
2001 and a net loss of approximately $25.4 million for the year ended December
31, 2000. If we do not achieve revenue growth and maintain our current cost of
structure (or reduce costs further), we could experience continuing operating
losses. These losses or any fluctuation in our operating results could cause the
market value of our common stock to decline further.
We have not been able to maintain a Nasdaq SmallCap listing, so our common stock
may become even more illiquid and the value of our securities may decline
further.
Nasdaq has, effective April 10, 2003, delisted our common stock, and our
common stock will likely trade on the National Association of Securities
Dealers' OTC Bulletin Board or in the over-the counter market in the so-called
"pink sheets" maintained by Pink Sheets LLC. Such alternative trading markets
are generally considered less liquid and efficient than Nasdaq, and although
trading in our stock is already relatively thin and sporadic, the liquidity of
our common stock will probably decline further because smaller quantities of
shares will likely be bought and sold, meaning that transactions could be
delayed. These factors could result in lower prices and larger spreads in the
bid and ask prices for our common stock. Reduced liquidity may reduce the value
of our common stock and our ability to generate additional funding.
19
We may need additional capital which, if not available to us, may alter our
business plan or limit our ability to achieve growth in revenues and which, if
available and raised, would dilute your ownership interest in us.
We incurred negative cash flows from operations in 2002 and, to date, have
continued to do so in 2003. Although we believe that we have sufficient cash to
fund existing operations for the balance of the year, we are pursuing sources of
working capital. Even after consideration of the additional funds raised in
2003, we may need to raise additional funds through public or private equity or
debt financings in order to:
o address working capital needs if collection of accounts receivable
declines;
o take advantage of acquisition or expansion opportunities;
o develop new services; or
o address unanticipated contingencies.
Our inability to obtain financing on terms acceptable to us, or at all,
may limit our ability to increase revenues or to achieve profitability. Our
stock price, like the stock price of many competitors in our industry, has been
depressed in recent periods, which could limit our ability to obtain any needed
financing on favorable or acceptable terms. In addition, if we are able to raise
additional capital through the sale of equity securities or through taking on
debt with an equity component, your investment in us would be diluted, which
could cause our stock price to further decline.
We anticipate acquiring more businesses, and we may incur increased operating
expenses without corresponding increased revenues, which may limit our ability
to achieve or maintain profitability and cause the price of our common stock to
decline.
A key component of our business strategy is to acquire like-minded peer
consultancies in geographic areas where we do not have a strong presence. We
also look for acquisition opportunities, without focusing on increasing our
geographic diversity, if there is an opportunity to strengthen a current service
offering or add a service offering which complements our current service
offerings. The risks of acquisitions include retaining clients, retaining key
employees, incurring higher than anticipated transaction expenses and other
unexpected expenses and diverting management's attention from daily operations
of our business. Acquiring businesses, especially in markets in which we have
limited prior experience, is risky. If we do not implement this strategy
successfully, we may incur increased operating expenses without increased
revenues, which could materially harm our operating results and stock price.
Because the market for our services may not grow during 2003, we may be unable
to become profitable.
We offer services in the IT services market, and that market started
contracting in the second half of 2001. We do not anticipate significant growth
in the IT services market in 2003. If demand for our services does not grow in
the future, or if we do not capture sufficient market share for these services,
we may be unable to achieve profitability.
Our results of operations may vary from quarter to quarter in future periods
and, as a result, we may not meet the expectations of our investors and
analysts, which could cause our stock price to fluctuate or decline.
Our revenues and results of operations have fluctuated significantly in
the past and could fluctuate significantly in the future. We incurred net losses
of $7.5 million and $2.5 million in the first and, second quarters of 2002,
respectively, and reported earnings of $0.9 million and $0.4 million in the
third and fourth quarters of 2002, respectively.
Our results may fluctuate due to the factors described in this Form 10-K,
as well as:
o the loss of or failure to replace any significant clients;
o variation in demand for our services;
o higher than expected bad debt write-offs;
o changes in the mix of services that we offer; and
o variation in our operating expenses.
20
A substantial portion of our operating expense is related to personnel
costs and overhead, which cannot be adjusted quickly and is, therefore,
relatively fixed in the short term. Our operating expenses are based, in
significant part, on our expectations of future revenues. If actual revenues are
below our expectations, we may not achieve our anticipated operating results.
Moreover, it is possible that in some future periods our results of operations
may be below the expectations of analysts and investors. In this event, the
market price of our common stock is likely to decline.
If we fail to keep pace with the rapid technological changes that characterize
our industry, our competitiveness would suffer, causing us to lose projects or
clients and consequently reducing our revenues and the price of our common
stock.
Our market and the enabling technologies used by our clients are
characterized by rapid, frequent, and significant technological changes. If we
fail to respond in a timely or cost-effective way to these technological
developments, we may not be able to meet the demands of our clients, which would
affect our ability to generate revenues and achieve profitability. We have
derived, and expect to continue to derive, a large portion of our revenues from
creating solutions that are based upon today's leading and developing
technologies and which are capable of adapting to future technologies. Our
historical results of operations may not reflect our new service offerings and
may not give you an accurate indication of our ability to adapt to these future
technologies.
Our failure to meet client expectations or deliver error-free services could
damage our reputation and harm our ability to compete for new business or retain
our existing clients, which may limit our ability to generate revenues and
achieve or maintain profitability.
Many of our engagements involve the delivery of information technology
services that are critical to our clients' businesses. Any defects or errors in
these services or failure to meet clients' specifications or expectations could
result in:
o delayed or lost revenues due to adverse client reaction;
o requirements to provide additional services to a client at no or a
limited charge;
o refunds of fees for failure to meet obligations;
o negative publicity about us and our services; and
o claims for substantial damages against us.
In addition, we sometimes implement critical functions for high profile
clients or for projects that have high visibility and widespread usage in the
marketplace. If these functions experience difficulties, whether or not as a
result of errors in our services, our name could be associated with these
difficulties and our reputation could be damaged, which would harm our business.
We may lose money on fixed-price contracts because we may fail to accurately
estimate at the beginning of projects the time and resources required to fulfill
our obligations under our contracts; the additional expenditures that we must
make to fulfill these contract obligations may cause our profitability to
decline or prevent us from achieving profitability and could reduce the price of
our common stock.
Although we provide consulting services primarily on a time and materials
compensation basis, approximately 27% of our consulting revenue was derived from
fixed-price, fixed-time engagements in 2002, and approximately 14% of revenues
were derived from fixed-price, fixed-time engagements in 2001. The percentage of
our revenues derived from fixed-price, fixed time engagements may increase in
the future, as influenced by changes in demand and market conditions. Our
failure to accurately estimate the resources required for a fixed-price,
fixed-time engagement or our failure to complete our contractual obligations in
a manner consistent with our projections or contractual commitments could harm
our overall profitability and our business. From time to time, we have been
required to commit unanticipated additional resources to complete some
fixed-price, fixed-time engagements, resulting in losses on these engagements.
We believe that we may experience similar situations in the future. In addition,
we may negotiate a fixed price for some projects before the design
specifications are finalized, resulting in a fixed price that is too low and
causing a decline in our operating results.
21
Our lack of long-term contracts with clients and our clients' ability to
terminate contracts with little or no notice reduces the predictability of our
revenues and increases the potential volatility of our stock price.
Our clients generally retain us on an engagement-by-engagement basis,
rather than under long-term contracts. In addition, our current clients can
generally reduce the scope of or cancel their use of our services without
penalty and with little or no notice. As a result, our revenues are difficult to
predict. Because we incur costs based on our expectations of future revenues,
our failure to predict our revenues accurately may cause our expenses to exceed
our revenues, which could cause us to incur increased operating losses. Although
we try to design and build complete integrated information systems for our
clients, we are sometimes retained to design and build discrete segments of the
overall system on an engagement-by-engagement basis. Since the projects of our
large clients can involve multiple engagements or stages, there is a risk that a
client may choose not to retain us for additional stages of a project or that
the client will cancel or delay additional planned projects. These cancellations
or delays could result from factors related or unrelated to our work product or
the progress of the project, including changing client objectives or strategies,
as well as general business or financial considerations of the client. If a
client defers, modifies, or cancels an engagement or chooses not to retain us
for additional phases of a project, we may not be able to rapidly re-deploy our
employees to other engagements and may suffer underutilization of employees and
the resulting harm to our operating results. Our operating expenses are
relatively fixed and cannot be reduced on short notice to compensate for
unanticipated variations in the number or size of engagements in progress. The
slowing in spending on business and IT consulting initiatives that began in the
second half of 2000 continues, and if current or potential clients cancel or
delay their IT initiatives, our business and results of operations could be
materially adversely affected.
We may not be successful in retaining our current technology alliances or
entering into new alliances, which could hamper our ability to market or deliver
solutions needed or desired by our clients and limit our ability to increase or
sustain our revenues and achieve or maintain profitability.
We rely on vendor alliances for client referral and marketing
opportunities, access to advanced technology and training as well as other
important benefits. These relationships are non-exclusive and the vendors are
free to enter into similar or more favorable relationships with our competitors.
Whether written or oral, many of the agreements underlying our relationships are
general in nature, do not legally bind the parties to transact business with
each other or to provide specific client referrals, cross-marketing
opportunities, or other intended benefits to each other, have indefinite terms,
and may be ended at the will of either party. We may not be able to maintain our
existing strategic relationships and may fail to enter into new relationships.
If we are unable to maintain these relationships, the benefits that we derive
from these relationships, including the receipt of important sales leads,
cross-marketing opportunities, access to emerging technology training and
certifications, and other benefits, may be lost. Consequently, we may not be
able to offer desired solutions to clients, which would result in a loss of
revenues and our inability to effectively compete for clients seeking emerging
or leading technologies offered by these vendors.
Because we operate in a highly competitive and rapidly changing industry,
competitors could cause us to lose business opportunities and limit our ability
to increase or sustain revenue levels.
Although our industry is experiencing significant consolidation, the
business areas in which we compete remain intensely competitive and subject to
rapid change. We expect competition to continue and to intensify. Our
competitors currently fall into several categories and include a range of
entities providing both general management and information technology consulting
services and internet services. Many of our competitors have longer operating
histories, larger client bases, and greater brand or name recognition, as well
as greater financial, technical, marketing, and public relations resources. Our
competitors may be able to respond more quickly to technological developments
and changes in clients' needs. Further, as a result of the low barriers to
entry, we may face additional competition from new entrants into our markets. We
do not own any technologies that preclude or inhibit competitors from entering
the general business areas in which we compete. Existing or future competitors
may independently develop and patent or copyright technologies that are superior
or substantially similar to our technologies, which may place us at a
competitive disadvantage. All of these factors could lead to competitors winning
new client engagements that we compete for. If this occurs, our ability to
generate increased revenues may be limited and we may not achieve profitability.
22
We may not be able to protect our intellectual property rights and, as a result,
we could lose competitive advantages which differentiate our solutions and our
ability to attract and retain clients.
Our success is dependent, in part, upon our intellectual property rights.
We rely upon a combination of trade secret, confidentiality and nondisclosure
agreements, and other contractual arrangements, as well as copyright and
trademark laws to protect our proprietary rights. We have no patents or pending
patent applications. We enter into confidentiality agreements with our
employees, we generally require that our consultants and clients enter into
these agreements, and we attempt to limit access to and distribution of our
proprietary information. Nevertheless, we may be unable to deter
misappropriation of our proprietary information or to detect unauthorized use
and take appropriate steps to enforce our intellectual property rights or
proprietary information.
We attempt to retain significant ownership or rights to use our internally
developed software applications which we can market and adapt through further
customization for other client projects. Under some of our client contracts, all
of our project developments are the property of the client and we have no right
or only limited rights to reuse or provide these developments in other client
projects. To the extent that we are unable to negotiate contracts which permit
us to reuse code and methodologies, or to the extent that we have conflicts with
our clients regarding our ability to do so, we may be unable to provide services
to some of our clients within price and timeframes acceptable to these clients.
Although we believe that our services, trade or service names, and
products do not infringe upon the intellectual property rights of others, claims
could be asserted against us in the future. If asserted, we may be unable to
successfully defend these claims, which could cause us to cease providing some
services or products and limit any competitive advantage we derive from our
trademarks or names.
If any of these events occur, our ability to differentiate ourselves and
compete effectively could be limited and we may lose revenue opportunities.
We occasionally agree not to perform services for our clients' competitors,
which may limit our ability to generate future revenues and inhibit our business
strategy.
In order to secure particularly large engagements or engagements with
industry leading clients, we have agreed on limited occasions not to perform
services, or not to utilize some of our intellectual property rights developed
for clients, for competitors of those clients for limited periods of time
ranging from one to three years. In our agreement with American Express, our
largest client in 2001 and 2000, we have agreed not to perform services for
competitors of American Express for one year after each project completion date
and not to assign consultants who have worked on American Express projects to
other clients' competitive projects for nine months after completing work for
American Express. These non-compete provisions reduce the number of our
prospective clients and our potential sources of revenue. These agreements also
may limit our ability to execute a part of our business strategy of leveraging
our business expertise in discreet industry segments by attracting multiple
clients competing in those industries.
Our long sales cycles make our revenues difficult to predict, which could cause
our revenues or profitability to be below analyst or investor expectations,
causing our stock price to fluctuate and decline significantly.
The timing of our revenues is difficult to predict because of the length
and variance of the time required to complete a sale. Our sales cycle typically
ranges in length from three months to nine months and is sometimes longer. Prior
to retaining us for a project, our clients often undertake an extensive review
of their systems, needs, and budgets and may require approval at various levels
within their organization. The length or unpredictability of our sales cycle
could cause our revenues or profitability to be below the expectations of
analysts or investors and our stock price to fluctuate significantly.
The loss of Mr. James G. Garvey, Jr., our founder, Chairman, President and Chief
Executive Officer, may harm our ability to obtain and retain client engagements,
maintain a cohesive culture, or compete effectively.
Our success will depend in large part upon the continued services of James
G. Garvey, Jr., our founder, Chairman, President and Chief Executive Officer. We
have an employment contract with Mr. Garvey. Mr. Garvey is precluded under his
agreement from competing against us for one year should he leave us. The loss of
Mr. Garvey's services could harm us and cause a loss of investor confidence in
our business, which could cause the trading price of our stock to decline. In
addition, if Mr. Garvey resigns to join a competitor or to form a competing
company, the loss of Mr. Garvey and any resulting loss of existing or potential
clients to any competitor could
23
harm our business. If we lose Mr. Garvey, we may be unable to prevent the
unauthorized disclosure or use by other companies of our technical knowledge,
practices, or procedures. In addition, due to the substantial number of shares
of our common stock owned by Mr. Garvey, the loss of Mr. Garvey's services could
cause investor or analyst concern that Mr. Garvey may sell a large portion of
his shares, which could cause a rapid and substantial decline in the trading
price of our common stock.
The holdings of Mr. Garvey may limit your ability to influence the outcome of
director elections and other matters subject to a stockholder vote, including a
sale of our company on terms that may be attractive to you.
James G. Garvey, Jr., our founder, Chairman, President and Chief Executive
Officer, currently owns approximately 61% of our outstanding common stock. Mr.
Garvey's stock ownership and management positions enable him to exert
considerable influence over our Company, including in the election of directors
and the approval of other actions submitted to our stockholders. In addition,
without the consent of Mr. Garvey, we may be prevented from entering into
transactions that could be viewed as beneficial to other stockholders, including
a sale of the Company. This could prevent you from selling your stock to a
potential acquirer at prices that exceed the market price of our stock, or could
cause the market price of our common stock to decline.
Our charter documents could make it more difficult for a third party to acquire
us, which could limit your ability to sell your stock to an acquirer at a
premium price or could cause our stock price to decline.
Our certificate of incorporation and by-laws may make it difficult for a
third party to acquire control of us, even if a change in control would be
beneficial to stockholders. Our certificate of incorporation authorizes our
board of directors to issue up to 5,000,000 shares of "blank check" preferred
stock. Without stockholder approval, the board of directors has the authority to
attach special rights, including voting and dividend rights, to this preferred
stock. With these rights, preferred stockholders could make it more difficult
for a third party to acquire our Company.
Our by-laws do not permit any person other than at least three members of
our board of directors, our President, the Chairman of the Board, or holders of
at least a majority of our stock to call special meetings of the stockholders.
In addition, a stockholder's proposal for an annual meeting must be received
within a specified period in order to be placed on the agenda. Because
stockholders have limited power to call meetings and are subject to timing
requirements in submitting stockholder proposals for consideration at meetings,
any third-party takeover or other matter that stockholders wish to vote on that
is not supported by the board of directors could be subject to significant
delays and difficulties.
If a third party finds it more difficult to acquire us because of these
provisions, you may not be able to sell your stock at a premium price that may
have been offered by the acquirer, and the trading price of our stock may be
lower than it otherwise would be if these provisions were not in effect.
The valuation model for companies such as ours has changed, and our inability to
achieve profitability may continue to materially adversely affect our stock
price.
When our stock became publicly traded in 2000, companies in our sector
were valued generally upon revenue growth, with little regard for profitability.
Companies in our sector are now generally measured on cash flows and profits. If
we are unable to achieve profitability and positive cash flow, our stock price
will continue to suffer and could further decline, and the liquidity for our
stock could deteriorate further as well.
Our stock repurchase plan may adversely affect the trading volume and liquidity
of our common stock and could cause our stock price to decline.
In December 2000, our board authorized a stock repurchase plan which
authorized us to purchase up to $2 million of our common stock on the open
market in compliance with applicable SEC regulations. In August 2001, our board
authorized an increase in the maximum amount from $2 million to $7 million.
During 2001, we repurchased 990,360 shares of our common stock at a cost of
approximately $5.3 million. We currently have no plan to repurchase additional
shares of our common stock. However, if we do repurchase more shares of our
common stock under this plan, the number of shares of our common stock
outstanding will decrease. This decrease would likely reduce the trading volume
of our common stock, adversely impacting the liquidity and value of our common
stock.
24
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
To date, we have not utilized derivative financial instruments or
derivative commodity instruments. We do not expect to employ these or other
strategies to hedge market risk in 2002. We invest our cash in money market
funds, which are subject to minimal credit and market risk. We believe that the
market risks associated with these financial instruments are immaterial.
All of our revenues are realized currently in U.S. dollars and are from
customers primarily in the United States. Therefore, we do not believe that we
currently have any significant direct foreign currency exchange rate risk.
25
Item 8. Financial Statements and Supplementary Data
Index to Consolidated Financial Statements
Page
Independent Auditors' Reports.................................................. 26
Consolidated Financial Statements:
Consolidated Balance Sheets as of December 31, 2002 and 2001.............. 28
Consolidated Statements of Operations for the years ended
December 31, 2002, 2001 and 2000...................................... 29
Consolidated Statements of Stockholders' Equity (Deficiency)
for the years ended December 31, 2002, 2001 and 2000.................. 30
Consolidated Statements of Cash Flows for the years ended
December 31, 2002, 2001 and 2000...................................... 31
Notes to Consolidated Financial Statements..................................... 32
26
INDEPENDENT AUDITORS' REPORT
Board of Directors
Integrated Information Systems, Inc.
Tempe, Arizona
We have audited the accompanying consolidated balance sheet of Integrated
Information Systems, Inc. as of December 31, 2002, and the related consolidated
statements of operations, stockholders' equity, and cash flows for the year then
ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Integrated
Information Systems, Inc. as of December 31, 2002 and the results of their
operations and their cash flows for the year then ended, in conformity with
accounting principles generally accepted in the United States of America.
As discussed in Note 17 to the consolidated financial statements, effective
January 1, 2002, the Company adopted certain provisions of Statement of
Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets."
As discussed in Notes 2 and 23, subsequent to December 31, 2002, the Company
obtained additional financing from a financial institution totaling $1,500,000
and also received $1,000,000 in proceeds from the sale of convertible preferred
stock to an officer and director.
HEIN + ASSOCIATES LLP
Phoenix, Arizona
March 7, 2003, except for Notes 2 and 23,
the date of which is April 4, 2003
27
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Integrated Information Systems, Inc.:
We have audited the accompanying consolidated balance sheet of Integrated
Information Systems, Inc. and subsidiary as of December 31, 2001, and the
related consolidated statements of operations, stockholders' equity
(deficiency), and cash flows for each of the years in the two-year period ended
December 31, 2001. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Integrated
Information Systems, Inc. and subsidiary as of December 31, 2001, and the
results of their operations and their cash flows for each of the years in the
two-year period ended December 31, 2001, in conformity with accounting
principles generally accepted in the United States of America.
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in note 2 to the
consolidated financial statements, the Company has suffered negative cash flows
from operations and has an accumulated deficit, that raise substantial doubt
about their ability to continue as a going concern. Management's plans in regard
to these matters are also described in note 2. The consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
As discussed in note 17 to the consolidated financial statements, effective July
1, 2001, the Company adopted the provisions of Statement of Financial Accounting
Standards ("SFAS") No. 141, "Business Combinations," and certain provisions of
SFAS No. 142, "Goodwill and Other Intangible Assets," as required for goodwill
and intangible assets resulting from business combinations consummated after
June 30, 2001.
KPMG LLP
Phoenix, Arizona
February 15, 2002
28
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
December 31,
--------------------
2002 2001
ASSETS -------- --------
Current assets:
Cash and cash equivalents ....................................................... $ 1,145 $ 5,235
Restricted cash ................................................................. 835 1,125
Accounts receivable, net (factored with recourse in 2002) ....................... 2,153 4,688
Unbilled revenues on contracts .................................................. 105 174
Prepaid expenses and other current assets ....................................... 177 550
-------- --------
Total current assets ......................................................... 4,415 11,772
Property and equipment, net ......................................................... 3,055 8,018
Goodwill ............................................................................ 5,080 3,187
Other assets ........................................................................ 730 1,402
-------- --------
$ 13,280 $ 24,379
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses ........................................... $ 3,523 $ 7,476
Amounts due under accounts receivable financing ................................. 2,898 --
Current installments of note payable ............................................ 253 --
Other current liabilities ....................................................... 216 --
Current installments of capital lease obligations ............................... 43 3,253
Deferred revenues on contracts .................................................. 270 750
-------- --------
Total current liabilities .................................................... 7,203 11,479
Capital lease obligations, less current installments ............................ 16 902
Note payable to bank ............................................................ 4,481 --
Other liabilities ............................................................... 979 --
-------- --------
Total liabilities ............................................................ 12,679 12,381
-------- --------
Commitments, contingencies and subsequent events (notes 2, 8, 11, 16, 19 and 23)
Stockholders' equity:
Preferred stock, $.001 par value 5,000,000 shares authorized and none
outstanding at December 31, 2002 and 2001 .................................... -- --
Common stock, $.001 par value; authorized 100,000,000 shares; issued and
outstanding 3,480,151 and 3,310,138 shares at December 31, 2002 and 2001,
respectively ................................................................. 3 3
Additional paid-in capital ...................................................... 94,561 94,167
Accumulated deficit ............................................................. (88,650) (76,836)
Accumulated other comprehensive loss ............................................ (31) (54)
-------- --------
5,883 17,280
Treasury stock, at cost, 990,360 shares at December 31, 2002 and 2001 ............... (5,282) (5,282)
-------- --------
Total stockholders' equity ................................................... 601 11,998
-------- --------
$ 13,280 $ 24,379
======== ========
See accompanying notes to consolidated financial
statements.
29
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Years Ended December 31,
-----------------------------------
2002 2001 2000
--------- --------- ---------
Revenues .................................................. $ 23,250 $ 31,252 $ 54,290
Cost of revenues .......................................... (17,452) (29,052) (34,542)
Other charges ............................................. -- (2,162) --
--------- --------- ---------
Gross profit ....................................... 5,798 38 19,748
--------- --------- ---------
Operating expenses:
Selling and marketing ................................. 3,452 5,620 8,278
General and administrative ............................ 12,866 29,694 39,279
Asset impairments and restructuring charges ........... (1,048) 14,882 --
Gain on settlement of payables ........................ (1,268) -- --
--------- --------- ---------
Total operating expenses ........................... 14,002 50,196 47,557
--------- --------- ---------
Loss from operations ............................... (8,204) (50,158) (27,809)
Interest and other income ................................. 86 1,390 3,197
Interest expense .......................................... (509) (627) (816)
--------- --------- ---------
Loss before cumulative effect of a change
in accounting principle ......................... (8,627) (49,395) (25,428)
Cumulative effect of a change in accounting principle ..... (3,187) -- --
--------- --------- ---------
Net loss ........................................... $(11,814) $(49,395) $(25,428)
========= ========= =========
Loss per share:
Loss before cumulative effect of a change in
accounting principle................................... $ (2.58) $ (13.57) $ (6.59)
Cumulative effect of a change in accounting principle ..... (.95) -- --
--------- --------- ---------
Loss per share, basic and diluted ..................... $ (3.53) $ (13.57) $ (6.59)
========= ========= =========
Weighted average common shares outstanding ................ 3,342 3,641 3,860
========= ========= =========
See accompanying notes to consolidated financial
statements.
30
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
(In thousands, except share amounts)
Accumulated Total
Common Stock Additional Other Stockholders'
------------------- Paid-In Accumulated Comprehensive Treasury Equity
Shares Amount Capital Deficit Loss Stock (Deficiency)
--------- ------ -------- ---------- ------------- ----- ------------
Balances, January 1, 2000 ............... 2,182,605 $ 2 $ 1,307 $ (2,013) $-- $ -- $ (704)
Issuance of common stock upon
conversion of preferred stock..... 907,634 1 24,292 -- -- -- 24,293
Issuance of common stock pursuant to
IPO, net of costs of $6,659,000... 989,000 1 67,515 -- -- -- 67,516
Issuance of common stock under
Employee Stock Purchase Plan ..... 31,020 -- 246 -- -- -- 246
Exercise of stock options ........... 23,125 -- 236 -- -- -- 236
Exercise of warrants ................ 3,400 -- 34 -- -- -- 34
Comprehensive loss:
Currency translation adjustments . -- -- -- -- (43) -- (43)
Net loss ......................... -- -- -- (25,428) -- -- (25,428)
--------- ------ -------- -------- ---------- ------ --------
Total comprehensive loss ......... -- -- -- -- -- -- (25,471)
--------- ------ -------- -------- ---------- ------ --------
Balances, December 31, 2000 ............. 4,136,784 4 93,630 (27,441) (43) -- 66,150
Issuance of common stock in
connection with acquisitions ..... 101,422 -- 365 -- -- -- 365
Issuance of common stock under
Employee Stock Purchase Plan ..... 38,292 -- 103 -- -- -- 103
Exercise of stock options ........... 24,000 -- 73 -- -- -- 73
Purchase of common stock, at cost ... (990,360) (1) (4) -- -- (5,282) (5,287)
Comprehensive loss:
Currency translation adjustments . -- -- -- -- (11) -- (11)
Net loss ......................... -- -- -- (49,395) -- -- (49,395)
--------- ------ -------- -------- ---------- ------ --------
Total comprehensive loss ......... -- -- -- -- -- -- (49,406)
--------- ------ -------- -------- ---------- ------ --------
Balances, December 31, 2001 ............. 3,310,138 3 94,167 (76,836) (54) (5,282) 11,998
Issuance of common stock in
connection with acquisitions ..... 150,000 -- 338 -- -- -- 338
Issuance of common stock for
consulting services .............. 20,000 -- 33 -- -- -- 33
Issuance of common stock for
rounding upon stock split......... 13 -- -- -- -- -- --
Warrants issued in relation to
issuance of Debt.................. -- -- 23 -- -- -- 23
Comprehensive loss:
Currency translation adjustments . -- -- -- -- 23 -- 23
Net loss ......................... -- -- -- (11,814) -- -- (11,814)
--------- ------ -------- -------- ---------- ------ --------
Total comprehensive loss ......... -- -- -- -- -- -- (11,791)
--------- ------ -------- -------- ---------- ----- --------
Balances, December 31, 2002 ............. 3,480,151 $ 3 $ 94,561 $(88,650) $(31) $(5,282) $ 601
========= ====== ======== ======== ========== ======= ========
See accompanying notes to consolidated financial
statements.
31
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Years Ended December 31,
-----------------------------------
2002 2001 2000
--------- --------- ---------
Cash flows from operating activities:
Net loss ............................................................. $(11,814) $(49,395) $(25,428)
Adjustments to reconcile net loss to net cash used in operating
activities:
Cumulative effect of a change in accounting principle ............ 3,187 -- --
Depreciation and amortization .................................... 4,042 7,830 6,895
Asset impairment, restructuring and other charges ................ (1,048) 17,044 --
Provision for doubtful accounts .................................. (757) 36 6,081
Gain on settlement of debt ....................................... (1,268) -- --
Change in assets and liabilities, net of acquisitions:
Accounts receivable .............................................. 4,367 2,058 (8,671)
Income tax receivable ............................................ -- 111 428
Unbilled revenues on contracts ................................... 69 502 213
Prepaid expenses and other assets ................................ 392 387 (2,255)
Other assets ..................................................... 643 -- --
Accounts payable and accrued expenses ............................ (2,860) (2,501) 2,791
Deferred revenues on contracts ................................... (559) 127 53
-------- -------- --------
Net cash used in operating activities ....................... (5,606) (23,801) (19,893)
-------- -------- --------
Cash flows from investing activities:
Capital expenditures ................................................. (174) (4,072) (16,885)
Proceeds from disposition of assets .................................. 291 -- --
Acquisitions ......................................................... (774) (2,785) --
-------- -------- --------
Net cash used in investing activities ....................... (657) (6,857) (16,885)
-------- -------- --------
Cash flows from financing activities:
Restricted cash ...................................................... 290 (1,125) --
Net borrowings (repayments) .......................................... 2,898 -- (1,015)
Repayments of debt ................................................... -- (9) (885)
Repayments of capital lease obligations .............................. (1,038) (4,390) (3,044)
Issuance of redeemable convertible preferred stock ................... -- -- 19,411
Proceeds of initial public offering, net of expenses ................. -- -- 67,516
Issuance of common stock and exercise of stock options ............... -- 176 516
Repurchase of common stock ........................................... -- (5,289) --
-------- -------- --------
Net cash provided by (used in) financing activities ......... 2,150 (10,637) 82,499
-------- -------- --------
Effect of exchange rate on cash ........................................... 23 (11) (43)
Increase (decrease) in cash and cash equivalents .......................... (4,090) (41,306) 45,678
Cash and cash equivalents, at beginning of year ........................... 5,235 46,541 863
-------- -------- --------
Cash and cash equivalents, at end of year ................................. $ 1,145 $ 5,235 $ 46,541
======== ======== ========
See accompanying notes to consolidated financial
statements.
32
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Nature of Business
Integrated Information Systems, Inc. ("IIS") and its wholly owned
subsidiary (collectively, the "Company") provides information technology related
professional services to businesses seeking to utilize technology to strengthen
relationships with customers and business partners.
We operate in a highly competitive, consolidating market. The information
technology services industry has experienced rapid growth followed by rapid and
significant contraction over a relatively short economic cycle. In past periods,
our rapid growth phase had required significant investments in infrastructure,
facilities, computer and office equipment, human resources and working capital
in order to meet the perceived demand. The increased demand did not materialize,
and since the third quarter of 2000, the market for our services has changed and
declined significantly.
(2) Liquidity and Continued Operations
The Company has incurred significant losses from operations over the past
3 years, has a substantial working capital deficit and an accumulated deficit of
$88,650,000 as of December 31, 2002. The Company was also in default under the
terms of its factoring agreement with its primary lender on December 31, 2002
and may have been in technical default on other borrowing arrangements with this
lender. However, all such defaults and potential defaults were waived by the
bank. As a result of these and other factors, there are concerns about the
liquidity of the Company at December 31, 2002.
The continuation of the Company is dependent upon its efforts to raise
additional capital, increase revenues, reduce expenses, and ultimately, to
achieve profitable operations. The Company has reduced is obligations and
expenses through settlements with creditors, landlords and lessors, reduced its
work force, and made substantial reductions to general and administrative
expenses throughout 2002 and through the first quarter of 2003.
Subsequent to December 31, 2002, the Company obtained the following:
o A $500,000 increase to its term loan;
o A $1,000,000 Line of Credit with its primary lender; and
o $1,000,000 of proceeds from the sale of preferred stock to an
individual who is an officer and director of the Company.
The Company also reached a new settlement with a primary creditor
resulting in the settlement of $901,000 of obligations recorded at December 31,
2002 for a one-time payment of $200,000 and the issuance of 100,000 shares of
common stock at $0.95 per share. Furthermore, the Company has made its cost
structure significantly more variable and believes it can continue to reduce
expenses if it is required.
While the Company cannot give any assurances that the above actions will
be sufficient to ultimately alleviate its liquidity concerns, or that additional
borrowings or capital could be obtained under satisfactory terms if they become
required, the Company does believe these actions will enable it to continue as a
going concern through December 31, 2003.
(3) Summary of Significant Accounting Policies
(a) Use of Estimates
The preparation of these financial statements in accordance with
accounting principles generally accepted in the United States requires the
Company to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. On an on-going basis, the Company evaluates its
estimates, including those related to long-term service contracts, bad debts,
intangible assets, income taxes, restructuring, and contingencies and
litigation. The Company bases its estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.
33
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The Company believes the following critical accounting policies affect its
more significant judgments and estimates used in the preparation of its
consolidated financial statements. The Company recognizes revenue and profit as
work progresses on long-term, fixed price contracts using the
percentage-of-completion method, which relies on estimates of total expected
contract revenue and costs. The Company follows this method since reasonably
dependable estimates of the revenue and costs applicable to various stages of a
contract can be made. Recognized revenues and profit are subject to revisions as
the contract progresses to completion. Revisions in profit estimates are charged
to income in the period in which the facts that give rise to the revision become
known. The Company maintains allowances for doubtful accounts for estimated
losses resulting from the inability of its customers to make required payments.
If the financial condition of the Company's customers were to deteriorate,
resulting in an impairment of their ability to make payments, additional
allowances may be required. The Company recorded goodwill and other intangible
assets from acquisitions during 2002 and 2001. The Company reviews its
intangible assets on a periodic basis to determine if the fair value supports
the carrying value of goodwill and other intangible assets. Future adverse
changes in market conditions or poor operating results could result in an
inability to recover the carrying value of the investments that may not be
reflected in the current carrying value of the intangible assets, thereby
possibly requiring material impairment charges in the future. The determination
of reporting units is integral to the intangible asset impairment test, and
requires significant judgments to be made. The Company records a valuation
allowance to reduce its deferred tax assets to the amount that is more likely
than not to be realized. In the event the Company were to determine that it
would be able to realize its deferred tax assets in the future in excess of its
net recorded amount, an adjustment to the deferred tax asset would increase
income in the period such determination was made. The Company records accruals
for the estimated future cash expenditures required from closing its vacated
offices. The accruals include estimates of future rent payments and settlements
until the obligation is canceled. Should actual cash expenditures differ from
the Company's estimates, revisions to the estimated liability for closing
vacated offices would be required. The Company evaluates the requirement for
future cash expenditures resulting from its contingencies and litigation. The
Company records an accrual for contingencies and litigation when exposures can
be reasonably estimated and are considered probable. Should the actual results
differ from the Company's estimates, revisions to the estimated liability for
contingencies and litigation would be required.
(b) Principles of Consolidation
The consolidated financial statements include the accounts of Integrated
Information Systems, Inc. and its wholly owned subsidiary, Emeric Systems
Private Limited. All significant intercompany accounts and transactions have
been eliminated in consolidation.
(c) Cash Equivalents
The Company considers all highly liquid investments with original
maturities of three months or less to be cash equivalents.
(d) Property and Equipment
Property and equipment are stated at cost, net of accumulated amortization
and depreciation. Depreciation is computed using the straight-line method over
the estimated useful lives of the related assets, which range from three to
seven years. Assets acquired under capital lease obligations and leasehold
improvements are amortized over the lesser of the estimated useful lives of the
assets or the lease terms.
(e) Goodwill
Goodwill represents the excess of purchase price over fair value of net
assets acquired.
(f) Impairment of Long-Lived Assets
The Company reviews long-lived assets and certain identifiable intangibles
be reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset to future net cash flows expected to be generated by the asset. If such
assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds the
34
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
fair value of the assets. Assets to be disposed of are reported at the lower of
the carrying amount or fair value less costs to sell.
(g) Revenue Recognition
Revenues for time-and-material contracts are recognized as the services
are rendered. Revenues pursuant to fixed fee contracts are generally recognized
as services are rendered using the percentage-of-completion method of accounting
(based on the ratio of labor hours incurred to total estimated labor hours).
Revenues from maintenance or post-contract support agreements are recognized as
earned over the terms of the agreements. Revenues from recurring services such
as application outsourcing operations are recognized as services are provided
each month.
Provisions for estimated losses on uncompleted contracts are made on a
contract-by-contract basis and are recognized in the period in which such losses
are determined. Unbilled revenues on contracts are comprised of earnings on
certain contracts in excess of contractual billings on such contracts. Billings
in excess of earnings are classified as deferred revenues on contracts.
(h) Concentration of Credit Risk
Financial instruments which potentially subject the Company to a
concentration of credit risk consist primarily of accounts receivable. The
Company performs ongoing credit evaluations of its customers and generally does
not require collateral on accounts receivable. The Company maintains allowances
for potential credit losses, and such losses have generally been within
management's expectations. The Company's customers operate in many industry
segments and are headquartered primarily in the United States of America.
(i) Stock Option Plan
The Company has elected to follow Accounting Principles Board Opinion No.
25, Accounting for Stock Issued to Employees (APB 25) and related
interpretations in accounting for its employee stock options and to adopt the
"disclosure only" alternative treatment under Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123). APB 25
requires no recognition of compensation expense for broad-based employee stock
purchase and option plans such as the plans provided by the Company, where the
exercise price is equal to the market value at the date of grant. However, under
SFAS 123, deferred compensation is recorded for the excess of the fair value of
the stock, on the date of the option grant, over the exercise price of the
option. The deferred compensation is amortized over the vesting period of the
option.
(j) Research and Development Costs
Research and development expenditures are charged to operations as
incurred. Expenditures for the years ended December 31, 2002, 2001, and 2000
were $0, $25,000, and $77,000, respectively and are included in general and
administrative expenses.
(k) Advertising Costs
Advertising costs are expensed as incurred. Advertising expense was
$43,000, $1,121,000, and $2,722,000 for the years ended December 31, 2002, 2001,
and 2000, respectively.
(l) Income Taxes
Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and 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.
(m) Fair Value of Financial Instruments
Fair value estimates are made at a specific point in time and are based on
relevant market information and information about the financial instrument; they
are subjective in nature and involve uncertainties and matters of judgment and,
therefore, cannot be determined with precision. These estimates do not reflect
any premium or
35
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
discount that could result from offering for sale at one time the Company's
entire holdings of a particular instrument. Changes in assumptions could
significantly affect these estimates.
The carrying amounts of accounts receivable, accounts payable and accrued
expenses are assumed to be the fair values because of the liquidity or
short-term maturity of these instruments. The carrying value of the Company's
long term debt is assumed to approximate fair value based on the interest rate
of the note.
(n) Supplemental Non-cash Disclosures
Non-cash investing and financing activities for the years ended December
31, 2002, 2001, and 2000 consisted of new capital lease obligations for property
and equipment of $0.4 million, $0.2 million and $9.3 million, respectively. In
addition, as a result of acquisitions during 2002 and 2001, the Company assumed
capital lease obligations totaling $24,000 and $0.2 million and issued common
stock totaling $0.4 million and $0.3 million, respectively.
In 2002, the Company assumed a $4,750,000 note in conjunction with the
acquisition of certain assets of Goliath Networks, Inc.
(o) Reclassifications
Certain reclassifications have been made to the prior years' consolidated
financial statement amounts to conform to the current year presentation; such
reclassifications had no effect on the reported net loss.
(p) Net Loss Per Share
For the years ended December 31, 2002, 2001 and 2000 there were 993,000,
887,000 and 553,000 stock options outstanding, respectively. Using the treasury
stock method, these options would have resulted in 87,000, 32,800 and 276,400
incremental shares in the diluted loss per share calculation in each year,
respectively. However, because of the Company's net loss in each year, all of
these options, as well as all warrants, have been excluded from the net loss per
share calculation because their effect would be antidilutive.
(4) Restricted Cash
During 2000, the Company signed a lease commitment for a new 71,000
square foot headquarters facility in Tempe, Arizona. In March and May 2001, the
Company deposited a total of $2,500,000 into a construction escrow account. The
funds in this account were being used to fund the build-out of tenant
improvements at the new facility. Through December 31, 2002, $2,091,000 of the
restricted cash was used, net of interest earned on the deposit, toward these
tenant improvements. In December 2001, in accordance with provisions of this
lease, the Company terminated its lease for this facility based on construction
delays. See note 8 and 19. No additional amounts are expected to be spent from
the escrow account and the Company is currently attempting to recover costs
invested in this facility.
In October 2002, the Company secured a revolving bank credit facility of
$4,200,000 funded through the sale of accounts receivable, a portion of which is
retained by the lender as a cash reserve against receivables sold with recourse.
At December 31, 2002, the amount of the cash reserve was $419,000.
In June 2001, the Company deposited $1,000,000 into a restricted
certificate of deposit account. The funds in this account serve as collateral
against various letters of credit totaling $1,000,000. As of December 31, 2002,
all amounts were used in connection with the Company's closure of excess office
space and renegotiation of certain leases. See note 8.
(5) Accounts Receivable
In October 2002, the Company entered into a financing agreement with a
bank to provide a revolving loan facility. The agreement permits the Company to
sell with recourse trade accounts receivable up to $4,200,000, is due on demand
and is subject to certain collateral limitations and covenants primarily related
to borrowing issuances. The Company pays a fee of 1.95% of the face amount of
the factored receivables. The agreement is collateralized by substantially all
of the assets of the Company. The agreement expires on October 14, 2003 with
automatic one-year renewals. At December 31, 2002, the Company had outstanding
borrowings of $2,898,000. For financial presentation purposes, the related
receivable and outstanding recourse liability have been included as an asset and
liability, respectively, on the balance sheet.
36
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Accounts receivable consist of the following (amounts in thousands):
December 31,
-------------------
2002 2001
-------- -------
Trade accounts receivable............................ $ 2,474 $11,518
Less: allowance for doubtful accounts................ (321) (6,830)
------- -------
$ 2,153 $ 4,688
======= =======
(6) Unbilled and Deferred Revenues on Contracts
Unbilled revenues on contracts are comprised of costs, plus earnings on
certain contracts, based on the percentage-of-completion method, in excess of
contractual billings on such contracts. These amounts are billed after year-end
and are expected to be collected within 90 days. Billings in excess of costs
plus earnings are classified as deferred revenues.
(7) Property and Equipment
A summary of property and equipment at December 31, 2002 and 2001 follows
(amounts in thousands):
December 31,
---------------------
2002 2001
-------- --------
Computer equipment .................................. $ 5,985 $ 8,926
Computer and telephone equipment under capital leases 220 8,803
Furniture and fixtures .............................. 3,049 3,271
Office equipment .................................... 564 754
Leasehold improvements .............................. 552 1,961
-------- --------
10,370 23,715
Less: accumulated depreciation and amortization ..... (7,315) (15,697)
-------- --------
Property and equipment, net .................... $ 3,055 $ 8,018
======== ========
(8) Asset Impairments, Restructuring and Other Charges
During 2001, the Company recorded asset impairments and restructuring
charges totaling $14,882,000. These charges included a $9,191,000 charge in the
second quarter of 2001, related to underutilized computer equipment and
leasehold improvements at our data center used for application outsourcing
services and a $5,691,000 charge in the fourth quarter of 2001 for expenses
incurred in connection with the closing and consolidating of six office
locations and abandoned leasehold improvements in an unoccupied seventh
location. The charge for closing and consolidating offices consisted of an
impairment charge totaling $3,556,000 and an accrual for future cash
expenditures, primarily rent-related obligations net of estimated future
sublease income, totaling $2,135,000. Additionally, the Company recorded other
charges related to the impairment of inventoried software licenses of $2,162,000
in the second quarter of 2001.
During the first quarter of 2002, commercial real estate markets in some
areas continued to be weaker than anticipated, and, accordingly, we re-evaluated
our accrual for future cash expenditures for closed office locations. In
addition, we executed a series of cost control initiatives to close and
consolidate three additional office locations. These activities resulted in
asset impairment and restructuring charges totaling $2,751,000 for the first
quarter of 2002. The charges consisted of an increase in the accrual to
terminate and exit closed facilities totaling $1,108,000, an accrual totaling
$1,039,000 for future cash expenditures attributable to closing and
consolidating three office locations, impairment charges to fixed assets
totaling $482,000 and impairment charges to rent deposits totaling $122,000. In
the second quarter of 2002, the Company recorded additional asset impairment
charges totaling $133,000 relating to the closure of an office.
During the third quarter of 2002, negotiations with the landlords of each
of the closed facilities and the remaining facilities resulted in a
restructuring of certain obligations and favorable settlements ultimately
37
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
consummated in October 2002. Accordingly, we again re-evaluated our accrual for
closed office locations resulting in a reduction of the restructuring charge of
$2,773,000.
During the fourth quarter of 2002, we completed a restructuring which
satisfied the obligations for certain real estate and equipment leases, certain
trade payables and accrued expenses for less than their recorded value. The
Company agreed to immediately pay $1,995,000 in cash and $1,221,000 in periodic
payments over the next five years satisfying $2,686,000 of recorded accounts
payable and accrued expenses, $3,074,000 of capital lease obligations and
$229,000 of other non-current liabilities. As a result of the comprehensive
settlement, a total of approximately $23.0 million of contractual obligations
were satisfied and a reduction of the restructuring reserve of $2,427,000 was
recognized in the fourth quarter due to the change in estimation of
restructuring charges. The Company also recognized a gain of $1,268,000 from the
settlement of trade payables for less than the face amount. The completion of
the comprehensive settlement with creditors was funded by a revolving bank
credit facility of $4,200,000 funded through the sale of accounts receivable at
a discount of 1.95%, of which $2,481,000 was used to fund the settlement,
including a $422,000 cash reserve account related to the receivables financing.
To obtain the financing, we pledged substantially all of our assets to the bank
as collateral. Additionally, the Company's key-man life insurance policy of
$5,000,000 was assigned to the bank, and the bank was given a warrant to
purchase 60,000 shares of our common stock at $5.00 per share. Our Chief
Executive Officer gave a $1.0 million personal guaranty to the bank as credit
support, and, in consideration of his guaranty, we have agreed to make quarterly
payments to him at an annual rate of 3% of the average outstanding balance under
the facility and to issue him, quarterly, warrants to acquire 4,000 shares of
our common stock for each $1.0 million in average outstanding balance under the
facility during the quarter. The warrants will have an exercise price of $5.00
per share and will remain exercisable as long as any amount is guaranteed and
for a period of one year thereafter, but for not less than five years from
issuance.
As of December 31, 2002, we had accrued liabilities for the future cash
expenditures attributable to these restructuring charges totaling $477,000 which
is classified as current accounts payable and accrued liabilities.
The activity for the years ended December 31, 2002 and 2001 is summarized
as follows:
Accrued
Closed
Facilities
Reserves
-----------
Balance, January 1, 2001...................... $ --
Rent reserves accrued ..................... 2,135,000
Reserve for escrow account................. 448,000
-----------
Balance, December 31, 2001.................... 2,583,000
Reserves accrued .......................... 2,147,000
Changes in previous estimates ............. (3,932,000)
Cash payments ............................. (321,000)
-----------
Balance December 31, 2002 .................... $ 477,000
===========
(9) Note Payable to Bank
At December 31, 2002, the Company owed $4,750,000 under a long-term note
with a bank. The note bears interest at 7.0%, payable quarterly with principal
payments beginning in 2004. The note is collateralized by accounts receivable,
inventory, equipment, furniture and intellectual property. Future principal
payments on the note are (amounts in thousands):
2003............................ $ --
2004............................ 282
2005............................ 329
2006............................ 4,139
------
$4,750
======
38
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(10) Capital Lease Obligations
The Company is obligated under capital leases primarily for computer
equipment and furniture that expire in 2003 and 2004. The leases meet the
various criteria of a capital lease and are, therefore, classified as capital
lease obligations.
Capital lease obligations reflect the present value of future rental
payments, discounted at the interest rate implicit in each of the leases. A
schedule of the future minimum lease payments required under the capital leases
after December 31, 2002 follows (amounts in thousands):
2003................................................................. $ 46
2004................................................................. 17
----
Total minimum capital lease payments............................ $ 63
Less: amounts representing interest (4.0 - 9.6%)..................... (4)
----
Capital lease obligation............................................. 59
Less: current installments of capital lease obligation............... (43)
----
Capital lease obligation, less current installments............. $ 16
====
The leased furniture and equipment has been included in property and
equipment at a total cost of $220,000 and $8,803,000 at December 31, 2002 and
2001, respectively. Accumulated depreciation related to this furniture and
equipment was $189,000 and $7,253,000 at December 31, 2002 and 2001,
respectively.
The Company acquired property and equipment and assumed capital lease
obligations totaling $24,000, $150,000 and $9,334,000 for the years ended
December 31, 2002, 2001 and 2000, respectively. Interest payments under capital
lease obligations are generally paid in the period incurred.
(11) Operating Lease Commitments
The Company has entered into various non-cancelable operating lease
agreements for office space, automobiles, and office equipment. The terms of
these agreements range from 6 months to 5 years and all of the leases require
monthly payments. The Company is generally responsible for all executory costs
including maintenance, insurance, utilities and taxes. Total rent expense was
$1,808,000, $5,474,000, and $3,616,000 for the years ended December 31, 2002,
2001, and 2000, respectively.
A summary of the future minimum lease payments under operating leases
after December 31, 2002 follows (amounts in thousands):
2003................................................. $ 755
2004................................................. 639
2005................................................. 433
2006................................................. 305
Thereafter........................................... 167
------
$2,299
======
During 2003, 2002 and 2001, the Company terminated leases for office space
in New York, Boston, Denver, Santa Monica and Irvine, California; Jacksonville,
Florida; Alpharetta, Georgia; Tempe, Arizona; and Bangalore, India. The above
future minimum lease payments exclude minimum payment amounts for the terminated
leases. See note 19.
(12) Income Taxes
The Company did not record a provision for federal or state income taxes
during 2002, 2001 and 2000 due to the net losses reported during those periods.
The Company also did not record a benefit for federal income taxes during 2002,
2001 and 2000 and no benefit for state income taxes during 2002, 2001 and 2000
due to limitations on the use of net operating loss carryforwards. The provision
for income taxes differs from the amount computed
40
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
by applying the statutory federal corporate income tax rate of 34% to income
before income taxes. The sources and tax effects of the differences are as
follows (amounts in thousands):
Years Ended December 31,
------------------------------------
2002 2001 2000
-------- --------- -------
Computed expected income tax benefit........................ $ (4,017) $ (16,794) $(8,646)
Nondeductible permanent differences......................... 21 88 78
State income tax benefit, net of federal benefit............ (768) (3,248) (1,715)
Inability to utilize net operating loss carryforwards....... 4,764 19,954 10,283
-------- --------- -------
$ -- $ -- $ --
======== ========= =======
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities are as follows
(amounts in thousands):
December 31
2002 2001
-------- --------
Deferred tax assets:
Bad debts ....................................... $ 130 $ 2,778
Debt issuance cost .............................. -- 35
Accrued vacation and other ...................... 148 206
Property and equipment, principally due to
differences in depreciation and impairment ... 6,010 5,668
Goodwill ........................................ 1,064 --
Charitable contribution carryforward ............ 52 48
Tax effect of net operating loss carryforward ... 25,984 22,187
-------- -------
Gross deferred tax assets ............................... 33,388 30,922
Less valuation allowance ................................ (33,358) (30,902)
-------- --------
Net deferred tax assets ................................. 30 20
-------- --------
Deferred tax liabilities:
Prepaid expenses and other deferred liabilities ..... (30) (20)
-------- --------
Gross deferred tax liabilities .......................... (30) (20)
-------- --------
Net deferred tax asset .................................. $ -- $ --
======== ========
At December 31, 2002, the Company had net operating loss carryforwards of
approximately $64,000,000 for U.S. federal and state income tax purposes that
expire in years 2018 through 2022. Due to the equity transactions that have
occurred with the Company, it is possible that the use of the net operating loss
carryforward may be limited in accordance with Section 382 of the Internal
Revenue Code. A determination as to this limitation will be made at a future
date as the net operating losses are utilized.
The valuation allowance for deferred tax assets as of December 31, 2002
and 2001 was $33,358,000 and $30,902,000, respectively. The net change in the
total valuation allowance for the years ended December 31, 2002 and 2001 was an
increase of $2,456,000 and $19,955,000, respectively. In assessing the
realizability of deferred tax assets, management considers whether it is more
likely than not that some portion or all of the deferred tax assets will not be
realized. The ultimate realization of deferred tax assets is dependent upon
generation of future taxable income during the periods in which those temporary
differences become deductible. Management considers the scheduled reversal of
deferred tax liabilities, projected future taxable income, and tax planning
strategies in making this assessment. Based upon the level of historical losses
and projections for future taxable income/losses over the periods in which the
deferred tax assets are deductible, management believes it is more likely than
not that the Company will not realize the benefits of these deductible
differences
(13) Convertible Preferred Stock
On February 26, 2003, the Company sold 20,000 shares of Series A 8%
Convertible Preferred Stock ("Series A 8%") to an officer and director for total
proceeds of $200,000. Series A 8% has a par value of $.001, a liquidation value
of $10.00 per share, carries a quarterly dividend of $0.80 per share, is
convertible into Common
41
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Stock at an initial conversion price of $2.50, subject to adjustment for
dilutive issuances, and votes only upon conversion. The Company may require
conversion into Common Stock as soon as the 20-day average of the last reported
sale of Common Stock is $10.00 or higher.
Additional preferred stock issuances subsequent to December 31, 2003 are
discussed in note 23.
(14) Stockholders' Equity
In March 2000, the Company sold 989,000 shares of common stock through an
Initial Public Offering at a price of $75.00 per share for cash proceeds of
$67,516,000, net of underwriters' discount and issuance costs of $6,659,000.
During 2001, the Company repurchased 990,360 shares of its common stock at
a cost of $5,282,000. These shares are reflected as treasury stock in the
accompanying consolidated financial statements.
In December 2002, the Company issued 20,000 shares of common stock valued
at $1.65 a share to a consultant as compensation for service.
On December 20, 2002, the Company effected a one-for-five reverse stock
split of the Company's common stock issued and outstanding immediately prior to
the effective time of the reverse stock split. The reverse stock split also
affects options, warrants and other securities convertible into or exchangeable
for shares of the Company's common stock that were issued and outstanding at the
effective time of the reverse stock split. No fractional shares were issued in
connection with the reverse stock split. The reverse split is reflected in these
financial statements as if it had happened on January 1, 2000. Accordingly, all
share amounts have been restated in these financial statements for all prior
periods presented.
(15) Employee Benefit Plans
(a) Retirement Plan
The Company established a qualified 401(k) salary deferral plan (defined
contribution plan) in July 1996. The plan covers substantially all full-time
employees who have completed ninety days of service. Subject to limits imposed
by Internal Revenue Service regulations and other options retained by the
Company affecting participant contributions, participants may voluntarily
contribute between 2% and 15% of their annual wages not to exceed limits
established by the Tax Reform Act of 1986. The Company may, at its discretion,
match 25% of the first 4% of participants' contributions. Participants are
immediately vested in the amount of their contributions. Participants vest over
a six-year period with respect to employer contributions. The Company's 401(k)
salary deferral plan expense was $60,000, $142,000, and $240,000 for the years
ended December 31, 2002, 2001, and 2000, respectively.
(b) Incentive Stock Option Plan and Warrants
The Company adopted the Integrated Information Systems, Inc. 1997
Long-Term Incentive Stock Option Plan in January 1997 ("1997 Plan") pursuant to
the Internal Revenue Code. Common stock reserved for grants to participants
under the 1997 Plan totals 1,200,000 shares at December 31, 2002 and 2001 and
900,000 shares at December 31, 2000. Options become exercisable over varying
periods up to five years and expire at the earlier of termination of employment
or ten years after the date of grant. The options under the 1997 Plan have been
granted at the fair market value of the Company's common stock at the date of
grant and, prior to the initial public offering, as determined by the Company's
board of directors. Per the 1997 Plan, options may be granted within a period of
ten years from the adoption date of the 1997 Plan. There were 651,565, 262,760
and 377,426 shares available for grant under the 1997 Plan as of December 31,
2002, 2001 and 2000, respectively.
The Company adopted the Integrated Information Systems, Inc. 2002
Broad-Based Stock Incentive Plan in February 2002 ("2002 Plan") pursuant to the
Internal Revenue Code. Common stock reserved for grants to participants under
the 2002 Plan totals 1,200,000 shares. Options become exercisable over varying
periods up to five years and expire at the earlier of termination of employment
or ten years after the date of grant. The options under the 2002 Plan have been
granted at the fair market value of the Company's common stock at the date of
grant. Per the 2002 Plan, options may be granted within a period of ten years
from the adoption date of the 2002 Plan. There were 707,148 shares available for
grant under the 2002 Plan as of December 31, 2002.
42
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The per share weighted average fair value of stock options granted under
the 1997 Plan and the 2002 Plan for the period ended December 31, 2002 was
$1.36. The per share weighted average fair value of stock options granted under
the 1997 Plan for the periods ended December 31, 2001 and 2000, was $3.55 and
$35.30, respectively. All options granted in 2002, 2001 and 2000 had an exercise
price equal to the market price on the date of grant. Per share weighted average
fair values are based on the date of grant using the Black-Scholes Method with
the following weighted average assumptions:
December 31,
------------------------------
2002 2001 2000
------ ------ ------
Expected life (years) ..................... 3.00 3.00 3.50
Risk-free interest rate.................... 2.98% 4.00% 5.00%
Dividend yield............................. 0.00% 0.00% 0.00%
Volatility................................. 250.00% 150.00% 150.00%
The following table summarizes information about stock option activity for
the years ending December 31, 2000, 2001 and 2002:
Options Outstanding
---------------------------------------------
Weighted
Average Exercisable
Shares Exercise Price Shares
---------- -------------- -----------
Outstanding, January 1, 2000................. 457,009 $10.75 56,329
Granted................................. 251,570 41.40 --
Exercised............................... (23,125) 10.20 --
Canceled................................ (162,880) 28.20 --
---------- -------------- -----------
Outstanding, December 31, 2000............... 522,574 20.05 112,821
Granted................................. 785,290 3.55 --
Exercised............................... (24,000) 3.00 --
Canceled................................ (394,744) 17.50 --
---------- -------------- -----------
Outstanding, December 31, 2001............... 889,120 6.95 129,468
Granted................................. 1,143,260 1.36 --
Exercised............................... 0 0.00 --
Canceled................................ (1,039,213) 4.83 --
---------- -------------- -----------
Outstanding, December 31, 2002............... 993,167 $ 2.51 203,216
========== ============== ===========
43
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The following table summarizes information about the stock options
outstanding at December 31, 2002 for both plans:
Weighted
Average Weighted Weighted
- ---------------------------- Remaining Average Average
Range Of Exercise Options Contractual Exercise Options Exercise
Prices Outstanding Life (Years) Price Exercisable Price
- ---------------------------- ----------- ------------ --------- ----------- ---------
$0.60 - 0.60..................... 152,000 9.64 $ 0.60 0 $ 0.00
$0.80 - 1.50..................... 118,472 9.34 1.19 31,811 1.07
$1.55 - $ 1.55................... 232,184 9.14 1.55 51,700 1.55
$2.40 - $ 2.40................... 184,000 9.89 2.40 0 0.00
$2.50 - $ 2.50................... 223,269 8.81 2.50 78,961 2.50
$3.30 - $34.06................... 79,302 7.79 8.85 39,638 8.29
$38.13 - $38.13................... 870 7.47 38.13 218 38.13
$47.65 - $47.65................... 2,000 7.02 47.65 620 47.65
$61.25 - $61.25................... 970 7.28 61.25 243 61.25
$75.00 - $75.00................... 100 7.21 75.00 25 75.00
--------- -------
$0.60 - $75.00................... 993,167 9.19 $ 2.51 203,216 $ 3.42
========= =======
Had the Company determined compensation cost based on the fair value at
the grant date for its stock options under SFAS 123, the Company's net loss
would have been increased to the pro forma amounts indicated below (amounts in
thousands):
Years Ended December 31,
------------------------------------
2002 2001 2000
--------- --------- ---------
Net loss as reported............................... $ (11,814) $ (49,395) $ (25,428)
Effect of recording stock options at fair value.... (47) (574) (149)
Pro forma ........................................ (11,861) (49,969) (25,577)
========= ========= =========
Net loss per share, as reported.................... (3.54) (13.57) (6.59)
Net loss per share, pro forma...................... (3.55) (13.72) (6.63)
During December 1997, the Company issued 20,000 warrants, subject to
anti-dilution adjustments from time to time, to purchase shares of common stock
in connection with long-term debt executed with a bank. The warrants are
exercisable at $10.00 per share and expire in December 2007. The debt has been
repaid, but the warrants are still outstanding at December 31, 2002. The value
assigned to the warrants, totaling $50,548, was charged to interest over the
term of the debt.
During April 1999, the Company issued 3,400 warrants to purchase shares of
common stock at an exercise price of $10.00 per share in connection with a
private placement memorandum. These warrants were exercised in April 2000.
During October 2002, the Company issued 60,000 warrants to purchase shares
of common stock in connection with long-term debt executed with a bank. The
warrants are exercisable at $5.00 per share and expire thirty days after the
final obligation of the Company to the bank. The remaining unamortized value
assigned to the warrants of $16,000 is shown as a debt discount at December 31,
2002.
During December 2002, the Company issued 8,335 warrants to James G.
Garvey, Jr. (Chairman, CEO and President of the Company), as a result of his
personal guarantee on the new financing executed with a bank in October 2002.
The warrants are exercisable at $5.00 per share and remain in effect as long as
the new financing is guaranteed by Mr. Garvey and for one year thereafter, but
not less than five years from issuance.
44
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(c) Employee Stock Purchase Plan
The Company established an Employee Stock Purchase Plan ("Purchase Plan")
in March 2000, under which 80,000 shares of common stock have been reserved for
issuance. Eligible employees may purchase a limited number of shares of the
Company's common stock at 85% of the market value at certain plan-defined dates.
Shares issued under the Purchase Plan were 0, 38,292 and 31,020 in 2002,
2001 and 2000, respectively. The net proceeds from shares issued under the
Purchase Plan were $0, $103,000 and $246,000 in 2002, 2001 and 2000,
respectively. At December 31, 2002, 70,688 shares were available for issuance
under the Purchase Plan.
(16) Acquisitions
As part of the Company's effort to adjust our structure to better address
a rapidly changing and declining IT services market, management developed and
began implementing an aggressive growth strategy through acquiring like-minded
peer consultancies. The acquisition target companies ideally have leading
competitive positions in regional and vertical markets, a proven track record of
providing Microsoft-based solutions, managers in place who are capable of
leading a regional division for the Company, a working culture and ethic similar
to the Company and are owned by consultants who remain active in the business.
These characteristics are why the Company pursued its acquisitions and are the
factors which contributed to a purchase price that resulted in Goodwill.
On August 20, 2001, the Company completed a series of transactions with
K2 Digital, Inc. ("K2"), a publicly held digital services firm based in New York
City. In that transaction, 24 management and consulting employees of K2 were
hired, certain related fixed assets were acquired and the leased office space of
K2 in New York City was assumed. The total purchase price consisted of cash
payments of $544,000 for certain K2 assets and $709,000 for the assumption of
liabilities. In the purchase price allocation, $927,000 was recorded as
goodwill. Due to continuing weak economic conditions subsequent to September 11,
2001, generally weak demand for IT services and other factors in the New York
market, management closed the New York K2 operations in July 2002.
On September 28, 2001, a similar series of transactions were completed
with STEP Technology, Inc. ("STEP"), a Portland, Oregon-based information
technology consulting firm. In that transaction, 54 management and consulting
personnel of STEP were hired, certain related assets were acquired and a portion
of STEP's office space in Portland was assumed. The total purchase price
consisted of cash payments of $1,140,000 for certain STEP assets and $1,041,000
for the assumption of liabilities. In the purchase price allocation, $1,433,000
was recorded as goodwill. In addition to the cash consideration, under the
purchase agreement, if in 2002, 2003, and 2004 annual earnings from STEP
operations are positive, STEP is entitled to additional consideration from this
transaction based on a percentage of the revenues generated and limited to an
agreed upon percentage of earnings.
On October 31, 2001, a series of transactions were completed with
INTEFLUX, Inc. ("INTEFLUX"), a privately-owned international technology
consulting firm based in Phoenix, Arizona, with operations in New York City and
London, England. In that transaction, 19 management and consulting employees of
INTEFLUX were hired, certain related assets were acquired and INTEFLUX's office
space in Phoenix and London was assumed. The total purchase price consisted of
cash payments of $50,000 and the issuance of common stock totaling $187,000 for
certain INTEFLUX assets and $319,000 for the assumption of liabilities. In the
purchase price allocation, $346,000 was recorded as goodwill. In addition to the
cash and common stock consideration, under the purchase agreement, if in 2002,
2003 and 2004 annual earnings from INTEFLUX operations are positive, INTEFLUX is
entitled additional consideration from this transaction based on a percentage of
the revenues generated and limited to an agreed upon percentage of earnings or
dollar amount.
On November 16, 2001, a series of transactions were completed with
Winfield Allen, Inc. ("Winfield Allen"), a Denver, Colorado-based information
technology consulting firm. In that transaction, 24 management and consulting
personnel of Winfield Allen were hired, certain related assets were acquired and
Winfield Allen's leased office space in Colorado was assumed. The total purchase
price consisted of cash payments of $84,000 and the issuance of common stock
totaling $136,000 for certain Winfield Allen assets, the assumption of a note
payable for $103,000 and $173,000 for the assumption of liabilities. In the
purchase price allocation, $358,000 was recorded as goodwill. In addition to the
cash and common stock consideration, under the purchase agreement, if in 2002,
2003, and 2004 annual earnings from Winfield Allen operations are positive,
Winfield Allen is entitled to
45
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
additional consideration from this transaction based on a percentage of the
revenues generated and limited to an agreed upon percentage of earnings or
dollar amount.
In connection with the adoption of FASB Statement of Financial Accounting
Standard No. 142, we were required to assess the impairment of our recorded
goodwill relating to the above acquisitions. All of the goodwill recorded
through December 31, 2001 totaling $3,064,000 and related acquisition costs of
$123,000 were written off in 2002 as a non-cash, cumulative effect of a change
in accounting principle.
On January 25, 2002, a transaction was completed with Goliath Networks,
Inc. ("Goliath"), a Madison, Wisconsin-based information technology consultancy.
In that transaction, 81 management and consulting personnel of Goliath were
hired, certain related assets acquired and the lease agreements for office space
of Goliath in Madison and Milwaukee, Wisconsin were assumed. In the purchase
price allocation, $4,829,000 was recorded as goodwill and intangibles. The
transaction was paid for with a combination of cash payments totaling $400,000,
the issuance of a note payable for $4,750,000 to a bank (see Note 9) and the
assumption of $209,000 of liabilities.
On October 15, 2002, a transaction was completed with Cunningham
Technology Group. ("CTG"), a privately-owned technology consulting firm based in
Phoenix, Arizona. In that transaction, 17 management and consulting personnel of
CTG were hired, certain related assets acquired and certain lease agreements for
computers were assumed. In the purchase price allocation, $326,000 was recorded
as goodwill and intangibles. The transaction was paid for with a combination of
cash payments totaling $374,000, the issuance of 150,000 shares of common stock
and the assumption of $131,000 of liabilities. CTG is entitled to additional
consideration from this transaction based on a percentage of the revenues
generated and limited to an agreed upon percentage of earnings or dollar amount.
As part of the 2001 and 2002 acquisitions, intangible assets excluding
goodwill totaling $682,000 were acquired consisting of non-compete agreements of
$325,000 and employee agreements of $357,000. The non-compete intangible assets
will be amortized over their contractual lives, which are generally five years.
The employee agreements' intangible assets were amortized over their contractual
lives, which were less than one year. The total goodwill recorded for the 2002
acquisitions was $5,080,000. It is estimated that most of this goodwill will be
deductible for tax purposes, subject to the utilization of the Company's net
operating losses. See note 12.
In connection with these acquisitions, the Company acquired accounts
receivable of $1,773,000 and fixed assets of $520,000. The Company issued 50,284
shares of common stock valued at $703,000, of which $43,000 was used to repay a
portion of an assumed note payable.
The Company's financial statements reflect the results of operations for
each acquisition from the transaction date. The following summary, prepared on a
pro forma basis, presents the results of operations as if the acquisitions had
been completed as of January 1, 2001 (amounts in thousands, except per share
amounts):
Year Ended
--------------------------
December 31,
--------------------------
2002 2001
-------- --------
(unaudited)
Revenues.............................. $ 27,630 $ 70,023
Operating losses...................... (8,358) (58,937)
Net loss.............................. (12,035) (59,182)
Net loss per share.................... $ (3.60) $ (15.20)
The pro forma results are not necessarily indicative of what actually
would have occurred if the transactions had been completed as of January 1,
2001. In addition, they are not intended to be a projection of future results
and do not reflect any synergies that might be achieved from combined
operations.
46
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(17) Goodwill
In September 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangible Assets" (SFAS 142). SFAS 142 became effective for us on January 1,
2002 and requires, among other things, the cessation of the amortization of
goodwill. In addition, the standard includes provisions for the reassessment of
the useful lives of existing recognized intangibles, a new method of measuring
reported goodwill for impairment and the identification of reporting units for
purposes of assessing potential future impairments of goodwill. We had recorded
$7,932,000 of goodwill relating to the five acquisitions completed after the
effective date of SFAS 141, and there has been no amortization expense recorded
in the accompanying financial statements. Among other requirements, SFAS 142
required us to complete a transitional goodwill impairment test on or before
June 30, 2002.
In connection with SFAS 142's transitional goodwill impairment evaluation,
the Statement required us to perform an assessment of whether there was an
indication that goodwill is impaired as of the date of the Company's adoption.
To accomplish this, we were required to identify the Company's reporting units
and determine the carrying value of each reporting unit by assigning the assets
and liabilities, including the existing goodwill and intangible assets, to those
reporting units as of January 1, 2002. Using the guidance provided in SFAS 142,
management determined that it has only one reporting unit. We were required to
determine the fair value of our reporting unit and compare it to the carrying
amount of the reporting unit within six months of January 1, 2002. To the extent
the carrying amount of a reporting unit exceeded the fair value of the reporting
unit, an indication existed that the reporting unit's goodwill may be impaired
and we would be required to perform the second step of the transitional
impairment test. In this step, we are required to compare the implied fair value
of the reporting unit goodwill with the carrying amount of the reporting unit
goodwill, both of which must be measured as of the date of adoption. The implied
fair value of goodwill is determined by allocating the fair value of the
reporting unit to all of the assets (recognized and unrecognized) and
liabilities of the reporting unit in a manner similar to a purchase price
allocation, in accordance with SFAS 141. The residual fair value after this
allocation will be the implied fair value of the reporting unit goodwill. If the
implied fair value of this reporting unit exceeds the carrying amount, we are
required to recognize an impairment loss.
The fair value of our reporting unit and the related implied fair value of
its respective goodwill was established using a market capitalization approach
supported by a discounted cash flow approach.
In June 2002, we completed the transitional goodwill impairment test in
accordance with SFAS 142, which resulted in a non-cash charge of $3,187,000 and
is reported in the caption "Cumulative effect of a change in accounting
principle" in the Company's condensed consolidated statements of operations. All
of the charge was related to the Company's acquisitions completed in 2001. The
primary factors that resulted in the impairment charge were the difficult
economic environment in the IT professional services sector and the liquidity
and continuation concerns of the Company at that time.
In accordance with SFAS 142, the fair value and carrying value of the
remaining goodwill of $5,080,000, relating to the acquisitions we completed in
the first and fourth quarters of 2002, were tested during the Company's annual
measurement date in the fourth quarter of 2002, which resulted in no additional
impairment charges.
(18) Significant Customers
One customer accounted for 6% of total revenue for the year ended December
31, 2002. Two customers accounted for 22% and 12% of total revenue for the year
ended December 31, 2001. Two customers accounted for 24% and 10% of total
revenue for the year ended December 31, 2000. One customer accounted for 35% of
total revenue for the year ended December 31, 1999.
One customer accounted for 9% of the total accounts receivable balance at
December 31, 2002. One customer accounted for 12% of the total accounts
receivable balance at December 31, 2001.
47
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(19) Contingencies and Related Party Transactions
During July and August 2001, four purported class action lawsuits were
filed in the United States District Court for the Southern District of New York
against the Company, certain of its current and former officers and directors
(the "Individual Defendants") and the members of the underwriting syndicate
involved in the Company's initial public offering (the "Underwriter
Defendants"). All four lawsuits have been transferred to Judge Scheindlin for
coordination with more than 300 similar cases. The suits generally allege that:
(1) the Underwriter Defendants allocated shares of the Company's initial public
offering to their customers in exchange for higher than standard commissions on
transactions in other securities; (2) the Underwriter Defendants allocated
shares of the Company's initial public offering to their customers in exchange
for the customers' agreement to purchase additional shares of our common stock
in the after-market at pre-determined prices; (3) the Company and the Individual
Defendants violated section 10(b) of the Securities Exchange Act of 1934 and/or
section 11 of the Securities Act of 1933; and (4) the Individual Defendants
violated section 20 of the Securities Exchange Act of 1934 and/or section 15 of
the Securities Act of 1933. The plaintiffs seek unspecified compensatory damages
and other relief. The Company has sought indemnification from the underwriters
of its initial public offering. In July 2002, we, as part of the group of
issuers of shares named in the consolidated litigation and the Individual
Defendants, filed a motion to dismiss the consolidated amended complaints. The
Underwriter Defendants filed motions to dismiss as well. Also in July 2002, the
plaintiffs offered to dismiss the Individual Defendants, without prejudice, in
exchange for a Reservation of Rights and Tolling Agreement from each Individual
Defendant. All of the Individual Defendants in our four lawsuits have entered
into such an agreement. On November 1, 2002, Judge Scheindlin heard oral
arguments on the motions to dismiss, and in February 2003, Judge Scheindlin
dismissed the section 10(b) claims against the Company but allowed the
plaintiffs to continue to pursue the remaining claims. The Company believes that
the claims against it are unfounded and without merit and intends to vigorously
defend this matter.
In December 2001, the Company terminated a lease with MCW Brickyard
Commercial, L.L.C. ("MCW") for new office space at 699 South Mill Avenue in
Tempe, Arizona as a result of MCW's failure to deliver the leased premises in a
timely manner and filed suit against MCW in Superior Court in Maricopa County,
Arizona to recover damages it incurred in preparing to move to the premises and
funds remaining in a construction escrow account. MCW filed an answer, denying
all liability and alleging that IIS caused delays in delivery of the leased
premises. During March 2002, MCW filed an amended answer and supplemental
counterclaim for lost rent, lost parking income, lost expense income,
commissions and unpaid construction costs. MCW also sought indemnity for
construction costs and its attorneys' fees and interest. In August 2002, MCW
filed a voluntary petition for reorganization under Chapter 11 of the U.S.
Bankruptcy Code, and the state court litigation was stayed as a result. The
Company and MCW signed a settlement agreement during March 2003, and MCW has
submitted the settlement to the bankruptcy court for approval. If it is not
approved, we will vigorously prosecute our claim against MCW and defend against
MCW's counterclaims, which we believe are without merit.
Additionally, the Company is, from time to time, party to various legal
proceedings arising in the ordinary course of business. The Company evaluates
such claims on a case-by-case basis, and its policy is to vigorously contest any
such claims which it believes are without merit.
During 2001, the Company incurred expenses totaling $133,000 for
consulting services provided by a board member. As of December 31, 2002, the
Company had a receivable of $25,000 from an officer and director.
An officer and director has guaranteed our accounts receivable financing,
and we have an ongoing, quarterly obligation to pay him cash and issue him
warrants for the continuing guaranty, based on the amount of financing
guaranteed during the quarter.
We sold preferred stock to an officer and director in February, March and
April of 2003. See Note 23.
(20) Recently Issued Accounting Pronouncements
In April 2002, the FASB issued Statement of Financial Accounting Standard
No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections" (SFAS 145), which addresses
financial accounting and reporting for reporting gains and losses from
extinguishment of debt, accounting for intangible assets of motor carriers and
accounting for leases. SFAS 145 requires that gains and losses from the early
extinguishment of debt should not be classified as extraordinary, as previously
required.
48
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
SFAS 145 also rescinds Statement 44, which was issued to establish accounting
requirements for the effects of transition to the provisions of the Motor
Carrier Act of 1980 (Public Law 96-296, 96th Congress, July 1, 1980). Those
transitions are completed; therefore, Statement 44 is no longer necessary.
Statement 145 also amends Statement 13 to require sale-leaseback accounting for
certain lease modifications that have economic effects that are similar to
sale-leaseback transactions. Statement 145 also makes various technical
corrections to existing pronouncements. Those corrections are not substantive in
nature. The provisions of this statement relating to Statement 4 are applicable
in fiscal years beginning after May 15, 2002. The provisions of this Statement
related to Statement 13 are effective for transactions occurring after May 15,
2002. All other provisions of this Statement are effective for financial
statements issued on or after May 15, 2002. The Company adopted the provisions
of SFAS 145 relating to Statement 4 and consequently recorded the gain on the
settlement of payables in operations. The adoption of the provisions of SFAS 145
relating to Statement 13 did not have a material impact on the Company's
condensed consolidated financial statements.
In June 2002, the FASB issued Statement of Financial Accounting Standards
SFAS No. 146, "Accounting for Exit or Disposal Activities" (SFAS 146). SFAS 146
addresses the recognition, measurement and reporting of costs associated with
exit and disposal activities, including restructuring activities. SFAS 146 also
addresses recognition of certain costs related to terminating a contract that is
not a capital lease, costs to consolidate facilities or relocate employees and
termination of benefits provided to employees that are involuntarily terminated
under the terms of a one-time benefit arrangement that is not an ongoing benefit
arrangement or an individual deferred compensation contract. SFAS 146 is
effective for exit or disposal activities that are initiated after December 31,
2002. The Company is in the process of evaluating the adoption of SFAS 146 and
its impact on the financial position or results of operations of the Company.
In August 2002, the FASB issued Statements of Financial Accounting
Standards No. 147, "Acquisitions of Certain Financial Institutions" (SFAS 147).
SFAS 147 requires financial institutions to follow the guidance in SFAS 141 and
SFAS 142 for business combinations and goodwill and intangible assets, as
opposed to the previously applied accounting literature. This statement also
amends SFAS 144 to include in its scope long-term customer relationship
intangible assets of financial institutions. The provisions of SFAS 147 do not
apply to the Company.
In December 2002, the FASB issued Statements of Financial Accounting
Standards No.148, "Accounting for Stock-Based compensation - Transition and
Disclosure - an amendment of FASB Statement 123" (SFAS 123). For entities that
change their accounting for stock-based compensation from the intrinsic method
to the fair value method under SFAS 123, the fair value method is to be applied
prospectively to those awards granted after the beginning of the period of
adoption (the prospective method). The amendment permits two additional
transition methods for adoption of the fair value method. In addition to the
prospective method, the entity can choose to either (i) restate all periods
presented (retroactive restatement method) or (ii) recognize compensation cost
from the beginning of the fiscal year of adoption as if the fair value method
had been used to account for awards (modified prospective method). For fiscal
years beginning December 15, 2003, the prospective method will no longer be
allowed. The Company currently accounts for its stock-based compensation using
the intrinsic value method as prescribed by Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees" and plans on continuing using
this method to account for stock options, therefore, it does not intend to
adopt the transition requirements as specified in SFAS 148. The Company has
adopted the new SFAS 148 disclosure requirements in these financial statements.
(21) Supplemental Financial Information
A summary of additions and deductions related to the allowance for
doubtful accounts for the years ended December 31, 2000, 2001 and 2002 follows
(in thousands):
49
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Balances Charged
At To Costs Balance
Beginning And At End Of
Of Year Expenses Deductions Year
--------- -------- ---------- ---------
Allowance for doubtful accounts
2000........................... $ 713 $11,825 $ (5,744) $ 6,794
2001........................... 6,794 898 (862) 6,830
2002........................... 6,830 (757) (6,394) 321
(22) Quarterly Financial Data (Unaudited)
A summary of the quarterly data for the years ended December 31, 2002 and
2001 follows (in thousands, except per share amounts):
Quarters Ended
--------------------------------------------------------------------------------------------------
Dec. 31, Sept. 30, June 30, Mar. 31, Dec. 31, Sept. 30, June 30, Mar. 31,
2002 2002 2002 2002 2001 2001 2001 2001
---------- ---------- --------- ---------- --------- --------- -------- ---------
Revenues ..................... $ 3,363 $ 4,491 $ 7,129 $ 8,267 $ 5,988 $ 6,172 $ 8,655 $ 10,437
Gross profit ................. 760 1,283 1,720 2,035 710 358 (2,156) 1,126
Operating expenses ........... 117 339 4,096 9,450 13,124 9,336 18,007 9,729
Income (loss) from operations 643 944 (2,376) (7,415) (12,414) (8,978) (20,163) (8,603)
Cumulative effect of a change
in accounting principle .. -- -- -- (3,187) -- -- -- --
Net income (loss) ........... $ 427 $ 913 $ (2,482) $(10,672) $(12,452) $ (8,771) $(19,953) $ (8,219)
Income (loss) per share:
Basic and diluted ........ $ .12 $ .28 $ (.75) $ (3.18) $ (3.80) $ (2.60) $ (5.25) $ (2.00)
Certain reclassifications have been made to quarterly financial data to conform
to the current presentation.
(23) Subsequent Events
On each of February 26, 2003 and April 2, 2003, the Company sold 20,000
shares of Series A 8% Convertible Preferred Stock ("Series A 8%") to an officer
and director for total proceeds of $400,000. Series A 8% has a par value of
$.001, a liquidation value of $10.00 per share, carries a quarterly dividend of
$0.80 per share, is convertible into Common Stock at an initial conversion price
of $2.50, subject to adjustment for dilutive issuances, and votes only upon
conversion. The Company may require conversion of the Series A 8% into Common
Stock as soon as the 20-day average of the last reported sale of Common is
$10.00 or higher.
On April 4, 2003, the Company sold 60,000 shares of Series B 12%
Convertible Preferred Stock ("Series B 12%) to an officer and director for total
proceeds of $600,000 and exchanged 40,000 shares of Series A 8% for 40,000
shares of Series B 12%. Series B 12% has a par value of $.001, a liquidation
value of $10.00 per share, carries a quarterly dividend of $1.20 per share, is
convertible into Common Stock at an initial conversion price of $1.10, subject
to adjustment for dilutive issuances, and votes only upon conversion. The
Company may require conversion of the Series B 12% into Common Stock as soon as
the 20-day average of the last reported sale is $4.40 or higher.
During March and April 2003, the Company obtained additional credit
from our lender for working capital purposes. The bank has loaned the Company an
additional $500,000, which was added to the existing note payable, deferred
principal payments under the note for a year, extended an additional one-year
$1.0 million revolving line of credit and allowed the Company to retain a
greater amount of proceeds from assets sales, with excess proceeds to be applied
against the note. To obtain this financing, the Company cancelled the warrant
given to the bank in October 2002 and gave the bank a warrant for 300,000 shares
at market price and reaffirmed the security interests previously given and the
assignment of the key-man life insurance. Additionally, the Company's Chief
Executive Officer gave a limited guaranty of $1.0 million for amounts drawn
under the revolving line of credit, and, in exchange, the Company gave him a
warrant for 300,000 shares at market price.
50
INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
On January 20, 2003, we dismissed KPMG LLP as the Company's independent
auditor. The decision to change independent auditors was approved by the Audit
Committee of the Company's Board of Directors and by the Company's full Board of
Directors.
During our two most recent fiscal years and the subsequent interim period
preceding the date of change of accountants, there were no disagreements between
the Company and KPMG LLP with respect to any matter of accounting principles or
practices, financial statement disclosure or auditing scope or procedure which
if not resolved to their satisfaction would have caused them to make reference
in connection with their opinion to the subject matter of the disagreement. The
audit reports of KPMG LLP on the Company's consolidated financial statements as
of and for the years ended December 31, 2001 and 2000 did not contain any
adverse opinion or disclaimer of opinion, nor were they qualified or modified as
to uncertainty, audit scope, or accounting principles, except as follows:
KPMG LLP's report on the Company's consolidated financial statements as of
and for the years ended December 31, 2001 and 2000, contained a separate
paragraph stating: "The accompanying consolidated financial statements have been
prepared assuming that the Company will continue as a going concern. As
discussed in note 1 to the consolidated financial statements, the Company has
suffered negative cash flows from operations and has an accumulated deficit,
that raise substantial doubt about their ability to continue as a going concern.
Management's plans in regard to these matters are also described in note 1. The
consolidated financial statements do not include any adjustments that might
result from the outcome of this uncertainty."
KPMG LLP's report also contained a paragraph stating, "As discussed in
note 16 to the consolidate financial statements, effective July 1, 2001, the
Company adopted the provision of Statement of Financial Accounting Standards
("SFAS") No. 141, "Business Combinations" and certain provisions of SFAS No.
142, "Goodwill and Other Intangible Assets" as required for goodwill and
intangible assets resulting from business combinations consummated after June
30, 2001."
On January 21, 2003, the Audit Committee of the Company's Board of
Directors engaged Hein + Associates LLP as the Company's independent auditor to
audit the Company's consolidated financial statements as of and for the year
ending December 31, 2002. During the fiscal years ended December 31, 2000, 2001
or 2002, or the subsequent interim period, we did not consult with Hein +
Associates LLP on: (i) either the application of accounting principles to a
specified transaction, either completed or proposed, or the type of audit
opinion that might be rendered on our financial statements; or (ii) the subject
of any disagreement, as defined in Item 304(a)(1)(iv) of Regulation S-K and
related instructions, or a reportable event, as described in Item 304(a)(1)(v)
of Regulation S-K.
Item 10. Directors and Executive Officers of the Registrant
The response to this Item regarding our directors and compliance with
Section 16(a) of the Exchange Act by our officers and directors will be
contained in the Proxy Statement for the 2002 Annual Meeting of Shareholders
under the captions "Election of Directors" and "Section 16(a) Beneficial
Ownership Reporting Compliance" and is incorporated by reference herein. The
response to this Item regarding our executive officers is contained in the
Supplemental Item -- "Executive Officers of the Registrant" found in Part I of
this report.
Item 11. Executive Compensation
The response to this Item will be contained in the Proxy Statement for the
2003 Annual Meeting of Shareholders under the captions "How are directors
compensated?" and "Executive Compensation" and is incorporated by reference
herein.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The response to the Item will be contained in the Proxy Statement for the
2003 Annual Meeting of Shareholders under the caption "Security Ownership of
Certain Beneficial Owners and Management" and is incorporated by reference
herein.
51
Item 13. Certain Relationships and Related Transactions
The response to this Item will be contained in the Proxy Statement for the
2003 Annual Meeting of Shareholders under the caption "Certain Relationships and
Related Transactions" and is incorporated by reference herein.
Item 14. Controls and Procedures
Under the supervision, and with the participation of, the Company's Chief
Executive Officer ("CEO") and Chief Financial Officer ("CFO"), management has
evaluated the effectiveness of the design and operation of the Company's
disclosure controls and procedures as of a date within 90 days of the filing
date of this annual report on Form 10-K. Based on that evaluation, the CEO and
CFO concluded that our disclosure controls and procedures have been designed and
are being operated in a manner that provides reasonable assurance that the
information required to be disclosed by us in reports filed under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in the SEC's rules and forms. There were no significant
changes in the Company's internal controls or in the other factors that could
significantly affect those controls subsequent to the date of the evaluation.
PART IV
Item 15. Exhibits, Financial Statements, Financial Statement Schedules, and
Reports on Form 8-K
15(a)(1),(2) Financial Statements
See the Index to Consolidated Financial Statements and Financial Statement
Schedule in Part II, Item 8.
15(a)(3) Exhibits
Exhibit
No.
- ------- Description
3.1 Amended and Restated Certificate of Incorporation (incorporated by
reference to Exhibit 3.3 to the Company's Quarterly Report on Form
10-Q (File No. 333-94861) for the period ended June 30, 2000).
3.1(a) Certificate of Amendment to Certificate of Incorporation
(incorporated by reference to Exhibit 3.1 to the Company's Current
Report on Form 8-K (File No. 333-94861) filed December 27, 2002).
3.1(b) Certificate of Designation of Series A 8% Convertible Preferred
Stock (incorporated by reference to Exhibit 3.1 to the Company's
Current Report on Form 8-K (File No. 333-94861) filed February 28,
2003).
3.1(c) Certificate of Designation of Series B 12% Convertible Preferred
Stock.
3.2 Amended and Restated By-Laws (incorporated by reference to Exhibit
3.2 to the Company's Annual Report on Form 10-K (File No. 333-94861)
for the period ended December 31, 2000).
4.1 Warrant granted to AnchorBank dated October 14, 2002 (incorporated
by reference to Exhibit 4.4 to the Company's Quarterly Report on
Form 10-Q (File No. 333-94861) for the period ended September 30,
2002).
4.2 Warrant granted to Imperial Bank dated December 18, 1997
(incorporated by reference to Exhibit 4.2 to the Company's
Registration Statement on Form S-1 (File No. 333-94861) dated
January 18, 2000).
4.3 Registration Rights Agreement between the Company and Cunningham
Enterprises, Inc. dated November 15, 2002.
4.4 Warrant granted to Anchor dated April 4, 2003.
10.1 Integrated Information Systems, Inc. 1997 Long Term Incentive Plan,
as amended (incorporated by reference to Exhibit 10.1 to the
Company's Registration Statement on Form S-1 (File No. 333-94861)
dated January 18, 2000).
10.2 Amended and Restated Integrated Information Systems, Inc. 2000
Employee Stock Purchase Plan (incorporated by reference to Exhibit
10.2 to the Company's Annual Report on Form 10-K (File No.
333-94861) for the period ended December 31, 2000).
10.3 Employment Agreement between the Company and James G. Garvey, Jr.
(incorporated by reference to Exhibit 10.3 to the Company's
Registration Statement on Form S-1 (File No. 333-94861) dated
January 18, 2000).
52
Exhibit
No.
- ------- Description
10.4 Sublease Agreement between the Company and Action Performance
Companies, Inc. dated March 28, 2000 (incorporated by reference to
Exhibit 10.1 to the Company's Current Report on Form 8-K (File No.
333-94861) filed March 31, 2000).
10.5 Equipment Sublease Agreement between the Company and goracing.com,
inc. dated March 28, 2000 (incorporated by reference to Exhibit 10.2
to the Company's Current Report on Form 8-K (File No. 333-94861)
filed March 31, 2000).
10.6 Equipment Sublease Agreement between the Company and Action
Performance Companies, Inc. dated March 28, 2000 (incorporated by
reference to Exhibit 10.3 to the Company's Current Report on Form
8-K (File No. 333-94861) filed March 31, 2000).
10.7 Asset Purchase Agreement between the Company and goracing.com, inc.
dated March 28, 2000 (incorporated by reference to Exhibit 10.4 to
the Company's Current Report on Form 8-K (File No. 333-94861) filed
March 31, 2000).
10.8 Services Agreement between the Company and goracing.com, inc. dated
March 28, 2000 (incorporated by reference to Exhibit 10.5 to the
Company's Current Report on Form 8-K (File No. 333-94861) filed
March 31, 2000).
10.9 Lease Agreement between the Company and AmberJack, Ltd. dated
December 8, 1998 (incorporated by reference to Exhibit 10.9 to the
Company's Registration Statement on Form S-1 (File No. 333-94861)
dated January 18, 2000).
10.10 Lease Agreement between the Company and AmberJack, Ltd. dated
September 7, 1999 (incorporated by reference to Exhibit 10.10 to the
Company's Registration Statement on Form S-1 (File No. 333-94861)
dated January 18, 2000).
10.11 Lease Agreement between the Company and AmberJack, Ltd. dated
September 7, 1999 (incorporated by reference to Exhibit 10.11 to the
Company's Registration Statement on Form S-1 (File No. 333-94861)
dated January 18, 2000).
10.12 Settlement and Lease Termination Agreement between the Company and
AmberJack, Ltd. dated January 22, 2003.
10.13 Settlement Agreement among the Company, Action Performance
Companies, Inc. and goracing.com, inc. dated October 4, 2002
(incorporated by reference to Exhibit 10.49 to the Company's
Quarterly Report on Form 10-Q (File No. 333-94861) for the period
ended September 30, 2002).
10.14 Sublease Agreement between the Company and Action Performance
Companies, Inc. dated October 4, 2002 (incorporated by reference to
Exhibit 10.50 to the Company's Quarterly Report on Form 10-Q (File
No. 333-94861) for the period ended September 30, 2002).
10.15 Lease Agreement between the Company and Information Technology Park
Limited dated August 2, 1999 (incorporated by reference to Exhibit
10.15 to the Company's Registration Statement on Form S-1 (File No.
333-94861) dated January 18, 2000).
10.16 Lease Agreement between the Company and 3930 Building Partnership
dated November 30, 1999 (incorporated by reference to Exhibit 10.16
to the Company's Registration Statement on Form S-1 (File No.
333-94861) dated January 18, 2000).
10.16(a) Lease Termination Agreement between the Company and 3930 Building
Partnership dated August 2, 2002 (incorporated by reference to
Exhibit 10.54 to the Company's Quarterly Report on Form 10-Q (File
No. 333-94861) for the period ended September 30, 2002).
10.17 Settlement Agreement between the Company and Comerica Bank -
California dated October 14, 2002 (incorporated by reference to
Exhibit 10.51 to the Company's Quarterly Report on Form 10-Q (File
No. 333-94861) for the period ended September 30, 2002).
10.18 Employment Agreement between the Company and Randall Eckel dated May
16, 2002 (incorporated by reference to Exhibit 10.47 to the Company's
Quarterly Report on Form 10-Q (File No. 333-94861) for the period
ended June 30, 2002).
10.19 Employment Agreement between the Company and Kenneth J. Biehl dated
March 21, 2002 (incorporated by reference to Exhibit 10.48 to the
Company's Quarterly Report on Form 10-Q (File No. 333-94861) for the
period ended June 30, 2002).
10.20 Form of Indemnity Agreement between the Company and its directors and
executive officers (incorporated by reference to Exhibit 10.20 to the
Company's Registration Statement on Form S-1 (File No. 333-94861)
dated January 18, 2000).
10.21 Lease Agreement between the Company and Riggs & Co. dated May 4, 2000.
53
Exhibit
No.
- ------- Description
10.23 Lease Agreement between the Company and Riggs & Co. dated February
8, 2000 (incorporated by reference to Exhibit 10.23 to the Company's
Registration Statement on Form S-1/A (File No. 333-94861) dated
March 14, 2000).
10.23(a) Lease Termination Agreement between the Company and Riggs & Co. dated
April 10, 2002 (incorporated by reference to Exhibit 10.54 to the
Company's Quarterly Report on Form 10-Q (File No. 333-94861) for the
period ended September 30, 2002).
10.24 Lease Agreement between the Company and Water Garden Company L.L.C.
(incorporated by reference to Exhibit 10.24 to the Company's
Quarterly Report on Form 10-Q (File No. 333-94861) for the period
ending March 31, 2000).
10.24(a) Lease Termination Agreement between the Company and Water Garden
Company L.L.C. dated October 14, 2002 (incorporated by reference to
Exhibit 10.60 to the Company's Quarterly Report on Form 10-Q (File
No. 333-94861) for the period ended September 30, 2002).
10.25 Lease Agreement between the Company and Deerfield Holdings, L.P.
dated March 12, 2000 (incorporated by reference Exhibit 10.25 to the
Company's Quarterly Report on Form 10-Q (File No. 333-94861) for the
period ending March 31, 2000).
10.25(a) Lease Surrender and Termination Agreement between the Company and
Deerfield Holdings, L.P. dated October 16, 2002 (incorporated by
reference to Exhibit 10.59 to the Company's Quarterly Report on Form
10-Q (File No. 333-94861) for the period ended September 30, 2002).
10.26 Lease Agreement between the Company and MONY/BDP I, L.L.C. dated May
26, 2000 (incorporated by reference to Exhibit 10.26 to the Company's
Quarterly Report on Form 10-Q (File No. 333-94861) for the period
ending June 30, 2000).
10.26(a) Settlement, Lease Termination Agreement And Mutual General Release
between the Company and Peridot Properties III, LLC (as assignee of
MONY/BDP I, L.L.C.) dated October 15, 2002 (incorporated by reference
to Exhibit 10.58 to the Company's Quarterly Report on Form 10-Q (File
No. 333-94861) for the period ended September 30, 2002).
10.27 Lease Agreement between the Company and PAC Court Associates, L.P.
dated May 16, 2000 (incorporated by reference to Exhibit 10.27 to the
Company's Quarterly Report on Form 10-Q (File No. 333-94861) for the
period ending June 30, 2000).
10.27(a) Lease Termination, Settlement Agreement and Mutual Release between
the Company and Pac Court Associates, L.P. dated September 30, 2002
(incorporated by reference to Exhibit 10.56 to the Company's
Quarterly Report on Form 10-Q (File No. 333-94861) for the period
ended September 30, 2002).
10.28 Sublease Agreement between the Company and UPS Telecommunications,
Inc. dated April 19, 2001 (incorporated by reference to Exhibit 10.28
to the Company's Quarterly Report on Form 10-Q (File No. 333-94861)
for the period ending March 31, 2001).
10.29 Sublease Agreement between the Company and iTRACS Corporation dated
February 27, 2001 and Addendum to Sublease Agreement between the
Company and iTRACS Corporation dated March 5, 2001 (incorporated by
reference to Exhibit 10.29 to the Company's Quarterly Report on Form
10-Q (File No. 333-94861) for the period ending March 31, 2001).
10.33 Assignment and Assumption of Lease and License Agreement between the
Company and K2 Digital, Inc. dated August 1, 2001 (incorporated by
reference to Exhibit 10.33 to the Company's Quarterly Report on Form
10-Q (File No. 333-94861) for the period ending September 30, 2001).
10.33(a) Stipulation of Settlement between the Company and 30 Broad Street
Associates, LLC dated October 14, 2002 (incorporated by reference to
Exhibit 10.57 to the Company's Quarterly Report on Form 10-Q (File
No. 333-94861) for the period ended September 30, 2002).
10.34 Lease Agreement between the Company and Resilient Floor Covering
Pension Fund dated September 28, 2001 (incorporated by reference
Exhibit 10.34 to the Company's Quarterly Report on Form 10-Q (File
No. 333-94861) for the period ending September 30, 2001).
10.34(a) Amendment #1 to Office Lease between the Company and Resilient Floor
Covering Pension Fund dated September 4, 2002 (incorporated by
reference to Exhibit 10.61 to the Company's Quarterly Report on Form
10-Q (File No. 333-94861) for the period ended September 30, 2002).
10.36 Office Lease between INTEFLUX, Inc. and SOFI-IV SIM Office Investors
II, Limited Partnership dated November 1, 2000 (incorporated by
reference to Exhibit 10.36 to the Company's Annual Report on Form
10-K (File No. 333-94861) for the period ended December 31, 2001).
54
Exhibit
No.
- ------- Description
10.36(a) Assignment and Assumption of Lease between the Company, INTEFLUX,
Inc. and CB Richard Ellis, Manager for SOFI - IV SIM Office
Investors, L.P. dated February 11, 2002 (incorporated by reference
Exhibit 10.46 to the Company's Quarterly Report on Form 10-Q (File
No. 333-94861) for the period ending March 31, 2002).
10.37 Standard Building Lease between Winfield Allen, Incorporated and A.H.
Root Limited Liability Company dated May 14, 1999 (incorporated by
reference to Exhibit 10.37 to the Company's Annual Report on Form
10-K (File No. 333-94861) for the period ended December 31, 2001).
10.37(a) Assignment and Assumption of Lease and Consent to Assignment and
Assumption of Lease between the Company, Winfield Allen, Inc. and
A.H. Root, Limited Liability Company dated November 11, 2001
(incorporated by reference Exhibit 10.47 to the Company's Quarterly
Report on Form 10-Q (File No. 333-94861) for the period ending March
31, 2002).
10.40 Lease Agreement between the Company and Ross Menard dated January 23,
2002 (incorporated by reference to Exhibit 10.40 to the Company's
Annual Report on Form 10-K (File No. 333-94861) for the period ended
December 31, 2001).
10.41 Subordinated Note in the amount of $4,250,000 by the Company to
AnchorBank, fsb dated January 25, 2002 (incorporated by reference to
Exhibit 10.41 to the Company's Annual Report on Form 10-K (File No.
333-94861) for the period ended December 31, 2001).
10.42 Selective Business Security Agreement between the Company and
AnchorBank, fsb dated January 25, 2002 (incorporated by reference to
Exhibit 10.42 to the Company's Annual Report on Form 10-K (File No.
333-94861) for the period ended December 31, 2001).
10.43 Employment Agreement between the Company and William A. Mahan
(incorporated by reference to Exhibit 10.43 to the Company's Annual
Report on Form 10-K (File No. 333-94861) for the period ended
December 31, 2001).
10.43(a) Separation Agreement and General Release between the Company and
William A. Mahan dated January 17, 2003.
10.44 Employment Agreement between the Company and Mark N. Rogers
(incorporated by reference to Exhibit 10.44 to the Company's Annual
Report on Form 10-K (File No. 333-94861) for the period ended
December 31, 2001).
10.45 Integrated Information Systems, Inc. 2002 Broad-Based Stock
Incentive Plan (incorporated by reference to Exhibit 10.45 to the
Company's Annual Report on Form 10-K (File No. 333-94861) for the
period ended December 31, 2001).
10.46 General Business Security Agreement between the Company and
AnchorBank, fsb dated October 14, 2002 (incorporated by reference to
Exhibit 10.52 to the Company's Quarterly Report on Form 10-Q (File
No. 333-94861) for the period ended September 30, 2002).
10.47 Modification to Subordinated Note in the amount of $4,750,000 by the
Company to AnchorBank, fsb dated October 14, 2002 (incorporated by
reference to Exhibit 10.53 to the Company's Quarterly Report on Form
10-Q (File No. 333-94861) for the period ended September 30, 2002).
10.48 Business Manager Agreement between the Company and AnchorBank, fsb
dated October 14, 2002.
10.49 Series A 8% Convertible Preferred Stock Purchase Agreement dated
February 26, 2003 between the Company and the Purchasers Named
Therein (incorporated by reference to Exhibit 10.1 to the Company's
Current Report on Form 8-K (File No. 333-94861) filed February 28,
2003).
10.50 Registration Rights Agreement dated February 26, 2003 between the
Company and the Purchasers Named Therein (incorporated by reference
to Exhibit 10.2 to the Company's Current Report on Form 8-K (File No.
333-94861) filed February 28, 2003).
10.51 Lease Agreement between the Company and Bel de Mar, L.L.C. dated
December 31, 2002.
10.52 Office Lease between the Company and American Family Mutual
Insurance Company dated February 6, 2003.
10.53 Employment Agreement between the Company and Donald H. Megrath dated
September 28, 2001.
10.54 Revised and Restated Subordinated Note in the amount of $5,250,000
by the Company to AnchorBank, fsb dated April 4, 2003.
10.55 Revolving Credit Agreement between the Company and AnchorBank, fsb
dated April 4, 2003
55
Exhibit
No.
- ------- Description
10.56 Revolving Credit Master Note in the amount of $1,000,000 by the
Company to AnchorBank, fsb dated April 4, 2003.
10.57 General Business Security Agreement between the Company and
AnchorBank, fsb dated April 4, 2003.
10.58 Amendment to Security Agreements between the Company and AnchorBank,
fsb dated April 4, 2003.
10.59 Series B 12% Convertible Preferred Stock Purchase Agreement dated
April 4, 2003 between the Company and the Purchasers Named Therein.
10.60 Registration Rights Agreement dated April 4, 2003 between the
Company and the Purchasers Named Therein.
21 List of Subsidiaries
23.1 Consent of Hein + Associates LLP
23.2 Consent of KPMG LLP
15(b) Reports on Form 8-K
Form 8-K filed October 22, 2002 to file as exhibit 99.1 a press release
titled "IIS Completes Comprehensive Financial Restructuring and Obtains
Bank Credit Facility Enabling Organic Growth and Consolidation
Strategies."
Form 8-K filed October 25, 2002 to file as exhibit 99.1 a press release
titled "Nasdaq Grants IIS Reasonable Period of Time to Achieve and
Sustain Compliance."
Form 8-K filed November 20, 2002 to file as exhibits 99.1 and 99.2
press releases titled "IIS Reports Announces Net Income of $0.9 Million
for Third Quarter" and "IIS Announces Acquisition of Cunningham
Consulting; Combined Company is the Leading Microsoft Gold Certified
Partner in Southwest U.S."
Form 8-K filed December 27, 2002 to file as exhibit 3.1 a Certificate
of Amendment to Certificate of Incorporation.
56
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
INTEGRATED INFORMATION SYSTEMS, INC.
Date: April 10, 2003 /s/ James G. Garvey, Jr.
---------------------------------------
James G. Garvey, Jr.
Chairman of the Board of Directors,
Chief Executive Officer and President
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Title Date
/s/ James G. Garvey, Jr. Chairman of the Board of Directors, April 10, 2003
- -----------------------
James G. Garvey, Jr. Chief Executive Officer and President
/s/ Donald H. Megrath Senior Vice President and Chief April 10, 2003
- -----------------------
Donald H. Megrath Financial Officer
/s/ John M. Blair Director April 10, 2003
- -----------------------
John M. Blair
/s/ R. Nicholas Loope Director April 10, 2003
- -----------------------
R. Nicholas Loope
/s/ Stephen W. Brown Director April 10, 2003
- -----------------------
Stephen W. Brown
/s/ Richard M. Gardner Director April 10, 2003
- -----------------------
Richard M. Gardner
57
Integrated Information Systems, Inc.
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
I, James G. Garvey, Jr., Chief Executive Officer, certify that:
1. I have reviewed this annual report on Form 10-K of Integrated Information
Systems, Inc. (the "Registrant");
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual
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
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 annual 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 annual report (the "Evaluation Date");
and
c) presented in this annual 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 Registrant's board of directors (or persons performing 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
annual report whether 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: April 10, 2003 /s/ James G. Garvey, Jr.
----------------------------------------
James G. Garvey, Jr.
Chairman of the Board of Directors,
Chief Executive Officer
and President
Integrated Information Systems, Inc.
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
I, Donald H. Megrath, Chief Financial Officer, certify that:
1. I have reviewed this annual report on Form 10-K of Integrated Information
Systems, Inc. (the "Registrant");
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual
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
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 annual 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 annual report (the "Evaluation Date");
and
c) presented in this annual 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 Registrant's board of directors (or persons performing 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
annual report whether 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: April 10, 2003 /s/ Donald H. Megrath
----------------------------------------
Donald H. Megrath
Senior Vice President,
Chief Financial Officer