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EX-3.1 - EMTEC INC/NJex3-1.htm
EX-31.1 - EMTEC INC/NJex31-1.htm
EX-32.2 - EMTEC INC/NJex32-2.htm
EX-32.1 - EMTEC INC/NJex32-1.htm
EX-31.2 - EMTEC INC/NJex31-2.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
______________

FORM 10-Q
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended May 31, 2010
 
Commission file number: 0-32789
 
EMTEC, INC.
(Exact name of registrant as specified in its charter)
 
Delaware
(State or other jurisdiction of incorporation or organization)
87-0273300
(I.R.S. Employer Identification No.)
 
525 Lincoln Drive
5 Greentree Center, Suite 117
Marlton, New Jersey 08053
(Address of principal executive offices, including zip code)

(856) 552-4204
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes  x    No  o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes   o   No  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company (see the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act).  (Check one)
 
Large accelerated filer o  Accelerated filer  o  Non-accelerated filer  o  Smaller reporting company  x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x
 
As of July 6, 2010, there were outstanding 16,054,931 shares of the registrant’s common stock.
 
 
 

 

EMTEC, INC.
FORM 10-Q FOR THE QUARTER ENDED MAY 31, 2010
 
Table of Contents
 
PART I – FINANCIAL INFORMATION
 
   
Item 1 - Financial Statements
 
 
 
Condensed Consolidated Balance Sheets
1
   
Condensed Consolidated Statements of Operations
2
   
Condensed Consolidated Statements of Cash Flows
3
   
Notes to Condensed Consolidated Financial Statements
4
   
Item 2  - Management’s Discussion and Analysis of Financial Condition and Results of Operations
21
   
Item 3  - Quantitative and Qualitative Disclosures About Market Risk
47
   
Item 4T - Controls and Procedures
48
   
PART II – OTHER INFORMATION
 
   
Item 1 – Legal Proceedings
49
   
Item 6 – Exhibits
50
   
SIGNATURES
51


 
 

 
PART I – FINANCIAL INFORMATION
 
Item 1.    Financial Statements
 
EMTEC, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED BALANCE SHEETS
 
(In Thousands, Except per Share and Share Data)
 
   
   
May 31, 2010
       
   
(Unaudited)
   
August 31, 2009
 
Assets
           
             
Current Assets
           
             
Cash
  $ 1,773     $ 1,713  
Receivables:
               
   Trade, less allowance for doubtful accounts
    32,467       29,463  
   Other
    1,805       2,184  
Inventories, net
    4,214       4,410  
Prepaid expenses and other
    2,875       2,184  
Deferred tax asset - current
    707       680  
                 
Total current assets
    43,841       40,634  
                 
Property and equipment, net
    1,474       1,390  
Intangible assets, net
    10,072       11,235  
Goodwill
    12,327       11,424  
Deferred tax asset- long term
    436       459  
Other assets
    95       131  
                 
Total assets
  $ 68,245     $ 65,273  
                 
Liabilities and Stockholders' Equity
               
                 
Current Liabilities
               
                 
Line of credit
  $ 13,844     $ 9,035  
Accounts payable
    25,128       25,390  
Current portion of long term debt - related party
    82       1,213  
Income taxes payable
    42       590  
Accrued liabilities
    5,643       6,723  
Customer deposits
    312       -  
Deferred revenue
    2,311       2,103  
                 
Total current liabilities
    47,362       45,054  
                 
Deferred tax liability- long term
    2,503       2,816  
Accrued liabilities
    176       180  
                 
Total liabilities
    50,041       48,050  
                 
Commitments and contingencies
               
Stockholders' Equity
               
Common stock $0.01 par value; 25,000,000 shares authorized;
18,744,520 and 18,059,679 shares issued and 15,879,931 and 15,195,090,
outstanding at  May 31, 2010 and August 31, 2009, respectively
    187       181  
Additional paid-in capital
    21,180       20,794  
Retained earnings
    2,194       1,671  
Accumulated other comprehensive income
    239       173  
      23,800       22,819  
Less: treasury stock, at cost, 2,864,589 shares
    (5,596 )     (5,596 )
                 
Total stockholders' equity
    18,204       17,223  
                 
Total liabilities and stockholders' equity
  $ 68,245     $ 65,273  
 
The accompanying notes are integral parts of these consolidated financial statements.
 
1

 
 
EMTEC, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 
(Unaudited)
 
(In Thousands, Except per Share and Share Data)
 
                         
   
For the Three Months Ended May 31,
   
For the Nine Months Ended May 31,
 
   
2010
   
2009
   
2010
   
2009
 
Revenues
                       
                         
Procurement services
  $ 39,536     $ 35,321     $ 122,193     $ 121,094  
Service and consulting
    13,970       13,898       40,994       40,106  
                                 
Total Revenues
    53,506       49,219       163,187       161,200  
                                 
Cost of Sales
                               
                                 
Cost of procurement services
    35,140       31,204       109,348       107,967  
Service and consulting
    10,285       10,369       29,310       30,666  
                                 
Total Cost of Sales
    45,425       41,573       138,658       138,633  
                                 
Gross Profit
                               
                                 
Procurement services
    4,396       4,117       12,845       13,127  
Service and consulting
    3,685       3,529       11,684       9,440  
                                 
Total Gross Profit
    8,081       7,646       24,529       22,567  
                                 
Operating expenses:
                               
                                 
Selling, general, and administrative expenses
    7,243       6,198       20,962       18,134  
Rent expense – related parties
    162       147       473       452  
Depreciation and amortization
    551       632       1,718       1,734  
Total operating expenses
    7,956       6,977       23,153       20,320  
                                 
Operating income
    125       669       1,376       2,247  
                                 
Other expense (income):
                               
Interest income – other
    (3 )     (5 )     (18 )     (16 )
Interest expense
    124       169       428       693  
Other expense
    (4 )     17       (12 )     21  
                                 
Income before income taxes
    8       488       978       1,549  
Provision for income taxes
    43       215       456       655  
Net income (loss)
  $ (35 )   $ 273     $ 522     $ 894  
                                 
Net income (loss) per common share
                               
    Basic and Diluted
  $ 0.00     $ 0.02     $ 0.03     $ 0.06  
                                 
Weighted Average Shares Outstanding
                               
    Basic
    15,071,515       14,629,231       15,071,515       14,629,231  
                                 
    Diluted
    15,071,515       14,888,272       15,258,822       14,883,734  
 
The accompanying notes are integral parts of these consolidated financial statements.

 
2

 
 
EMTEC, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
(Unaudited)
 
(In Thousands)
 
   
For the Nine Months Ended May 31,
 
   
2010
   
2009
 
Cash Flows From Operating Activities
           
Net income
  $ 522     $ 894  
                 
Adjustments to Reconcile Net Income to Net
               
Cash Provided By Operating Activities
               
Depreciation and amortization
    493       626  
Amortization related to intangible assets
    1,225       1,108  
Deferred income taxes (benefit)
    (331 )     (240 )
Stock-based compensation
    393       87  
Indemnification of professional fees
    -       (270 )
                 
Changes In Operating Assets and Liabilities
               
Receivables
    (2,562 )     8,017  
Inventories
    196       (6,978 )
Prepaid expenses and other assets
    (631 )     (174 )
Accounts payable
    (275 )     1,291  
Customer deposits
    312       (1 )
Income taxes payable
    (548 )     (93 )
Accrued liabilities
    (1,175 )     (855 )
Deferred revenue
    182       (36 )
Net Cash Provided By (Used In) Operating Activities
    (2,199 )     3,376  
                 
Cash Flows From Investing Activities
               
Purchases of property and equipment
    (563 )     (795 )
Acquisition of businesses, net of cash acquired
    (294 )     (1,129 )
Acquisitions related contingent earnout/tax settlement
    (606 )     (165 )
Net Cash Used In Investing Activities
    (1,463 )     (2,089 )
                 
Cash Flows From Financing Activities
               
Net increase  in line of credit
    4,809       2,198  
Repayment of debt
    (1,146 )     (2,723 )
Net Cash Provided By Financing Activities
    3,663       (525 )
                 
Effect of rate changes on cash
    59       200  
                 
Net Increase in Cash
    60       962  
Beginning Cash
    1,713       2,025  
                 
Ending Cash
  $ 1,773     $ 2,987  
Supplemental Disclosure of Cash Flow Information
               
Cash paid during the period for:
               
Income taxes
  $ 2,094     $ 697  
Interest
  $ 713     $ 780  
                 
Supplemental Schedule of Non Cash Investing and Financing Activities
               
Indemnification receivable due from former shareholders settled by the amounts
  due to former shareholders
  $ -     $ 631  
Note payable issued, acquisition of Capital Stock of Koan-IT
  $ -     $ 397  
 
The accompanying notes are integral parts of these consolidated financial statements.
 
 
3

 

EMTEC, INC
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.  Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X. Accordingly, they do not include all of the information and note disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included in the accompanying unaudited condensed consolidated financial statements.  Quarterly results are not necessarily indicative of results for the full year. For further information, refer to the annual financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 2009.

2.  General

Description of Business

Emtec, Inc. a Delaware corporation (the “Company”) established in 1964, is a systems integrator providing information technology (“IT”) services and products to the federal, state, and local governments, and education and commercial markets. Emtec helps clients identify and prioritize areas for improvement and then implements process, technology and business application improvements that reduce costs, improve service and align the delivery of IT with the needs of their organizations.  The Company’s value-based management methods, coupled with IT technology, consulting and development services, allow us to address a wide range of specific client needs, as well as support broader IT transformation initiatives.  The Company’s client base is comprised of departments of federal, state and local governments in the United States and Canada, and schools and commercial businesses throughout the United States and Canada.
 
Principles of Consolidation
 
The consolidated financial statements for the three and nine months ended May 31, 2010 include the accounts of the Company and its wholly-owned subsidiaries, Emtec, Inc., a New Jersey Corporation (“Emtec NJ”), Emtec Viasub LLC (“Emtec LLC”), Emtec LLC’s wholly-owned subsidiary Emtec Federal, Inc. (“Emtec Federal”), Emtec Global Services LLC (“EGS”), EGS’ wholly-owned subsidiaries Luceo, Inc. (“Luceo”), eBusiness Application Solutions, Inc. (“eBAS”), Aveeva, Inc. (“Aveeva”), Emtec Services Mauritius (“Emtec Mauritius”), and Emtec Mauritius’s subsidiary Emtec Software India Private Limited (“Emtec India”), formerly Aviance Software India Private Limited (“Aviance”), Emtec Infrastructure Services Corporation (“EIS-US”), and EIS-US’s wholly-owned subsidiaries Emtec Infrastructure Services Canada Corporation (“EIS-Canada”), which is referred to in this report as KOAN-IT, and KOAN-IT (US) Corp. (“KOAN-IT (US)”). Significant intercompany account balances and transactions have been eliminated in consolidation.

On June 4, 2010, Emtec Federal acquired all of the outstanding stock of Secure Data, Inc. (“SDI”).  SDI’s accounts will be included in future consolidated financial statements of the Company.
 
 
4

 
 
Segment Reporting
 
The Company divides its operating activity into two operating segments for reporting purposes: Emtec Infrastructure Services Division (“EIS”) and Emtec Global Services Division (“EGS”). EIS consists of the Company’s historical business (“Systems Division”) which includes Emtec NJ, Emtec LLC, Emtec Federal and the business service management solutions offered by the Information Technology Service Management (“ITSM”) practice. EGS is the Company’s enterprise applications services solutions and training business including its Enterprise Resource Planning (“ERP”) and Application Development practice and its Business Analysis and Quality Assurance Practice.
 
Accounting Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period, including, but not limited to, receivable and inventory valuations, impairment of goodwill and other long-lived assets and income taxes.  Management’s estimates are based on historical experience, facts and circumstances available at the time and various other assumptions that are believed to be reasonable under the circumstances.  The Company reviews these matters and reflects changes in estimates as appropriate.  Actual results could differ materially from those estimates.

Goodwill

Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired companies.  The changes in the carrying amount of goodwill for the nine months ended May 31, 2010, by reportable segments are as follows (in thousands):
 
   
EIS
   
EGS
   
Total
 
Balance at August 31, 2009
  $ 9,683     $ 1,741     $ 11,424  
Foreign currency translation effect of Canadian goodwill
    20       -       20  
Increase in goodwill arising due to Luceo and Koan-IT acquisition related earnout payments
    316       290       606  
Goodwill acquired during the year
    -       277       277  
Balance at May 31, 2010
  $ 10,019     $ 2,308     $ 12,327  
 
KOAN-IT Corp: The contingent payment of $316,000 for the first year anniversary of closing to the former shareholders of KOAN-IT was accrued in the three months ended May 31, 2010, and paid in June 2010.  This contingent payment is treated as additional purchase price and increased goodwill.

Luceo, Inc.: The contingent payment of $290,000 for the second year anniversary of closing to Mr. Natarajan was accrued in the three months ended May 31, 2010, and paid in June 2010.  This contingent payment is treated as additional purchase price and increased goodwill.

SARK Infotech Private Limited: On April 1, 2010, Emtec India acquired certain assets of SARK Infotech Private Limited (“SARK”), a software consulting company based in Mumbai, India. The Company recorded $277,000 in goodwill during this quarter from this acquisition.

 
5

 
 
In accordance with Accounting Standard Codification (“ASC”) 350 “Intangibles- Goodwill and Other,” goodwill is not amortized but tested for impairment annually, or more frequently, if events or changes in circumstances indicate that the asset might be impaired.  Goodwill is tested for impairment at one level below an operating segment (also known as a component) in accordance with the guidance of FASB ASC Topic 350. These reporting units are comprised of Systems Division, KOAN-IT, Luceo and eBAS/Aveeva.  The Company has set an annual impairment testing date of June 1.

An impairment charge will be recognized only when the implied fair value of a reporting unit, including goodwill, is less than its carrying amount.  The impairment determination is made at the reporting unit level and consists of two steps. First, the Company determines the fair value of the reporting unit and compares it to its carrying amount. Second, if the carrying amount of the reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with ASC 805 “Business Combinations.”  The residual fair value after this allocation is the implied fair value of the reporting unit goodwill.

The following table presents a summary of the Company’s goodwill by reporting unit at May 31, 2010, as well as critical assumptions used in the valuation of the reporting units at June 1, 2009, the Company’s annual testing date:
 
   
Goodwill
                                 
Reporting Unit
 
$'000
   
% of total
   
Discount
Rate
   
Terminal
Growth Rate
   
Years of Cash Flow before Terminal Value
   
% By Which Reporting Unit Fair Value Exceeds its Carrying Value*
 
Systems Division
  8,817     71.5%     15.6 %     4.0 %     10       68.8 %  
Luceo
  1,961     15.9%     17.5 %     4.0 %     10       992.3 %  
eBAS/Aveeva
  70     0.6%     17.1 %     4.0 %     10       887.7 %  
KOAN-IT
  1,202     9.8%     17.5 %     4.0 %     10       4652.0 %  
SARK**
  277     2.2%     n/a       n/a       n/a       n/a    
Total
  12,327     100.0%                                  
                                             
*    As of June 1, 2009
                                           
** Acquired April 1, 2010
                                           
 
At the last annual impairment testing date of June 1, 2009, the Company’s market capitalization was less than its carrying value.  Since the Company’s stock does not trade frequently and with the stock price being volatile, management believes that other valuation methods are more appropriate to reflect the fair value of the Company.  Accordingly, the Company determined the fair value of its Systems Division reporting unit using an equally weighted combination of the discounted cash flow and guideline company valuation approaches.  For the Company’s remaining reporting units (Luceo, eBAS/Aveeva and KOAN-IT), fair value was determined using the discounted cash flow valuation approach, as in the Company’s opinion, this method currently results in the most accurate calculation of fair value for these reporting units.    The rationale for relying solely on one valuation approach for these reporting units was that these reporting units were all acquired by the Company within the last two years (as of August 31, 2009) and have relatively brief operating histories from which to base a comparison to publicly traded companies under the guideline company valuation approach.

 
6

 
 
Determining the fair value of a reporting unit requires judgment and the use of significant estimates and assumptions. Such estimates and assumptions include revenue growth rates, operating margins, discount rates, weighted average costs of capital and views on future market conditions, among others. We believe that the estimates and assumptions used in our impairment assessments are reasonable and based on available market information, but variations in any of the assumptions could result in materially different calculations of fair value and determinations of whether or not an impairment is indicated. As part of this analysis, the Company engaged an external valuation firm to review and validate the Company’s impairment analysis to value its goodwill.

Under the discounted cash flow method, the Company determined fair value based on the estimated future cash flows of each reporting unit, discounted to present value using risk-adjusted  discount rates, which reflect the overall level of inherent risk of a reporting unit and the rate of return an outside investor would expect to earn. Cash flow projections are derived from budgeted amounts and operating forecasts (typically a five-year model) plus an estimate of later period cash flows, all of which are developed by the Company. Subsequent period cash flows are developed for each reporting unit using growth rates that the Company believes are reasonably likely to occur along with a terminal value derived from the reporting unit’s earnings before interest, taxes, depreciation and amortization (“EBITDA”).
 
Under the guideline company approach, the Company determined the estimated fair value of its Systems Division by comparison to prices paid for similar companies. The search for guideline companies began with examination of reporting public companies, which were in similar businesses as the Systems Division. From this list, we identified companies that were similar to the Systems Division business characteristics with regard to product offerings, services performed, growth rates, profitability and size in terms of assets held and volume of sales.   This approach to value is based on the premise that prices paid for the stock of one company can provide an indication of what a willing buyer would pay for the stock of another company sharing similar characteristics.  More specifically, this approach involves establishing relationships between the price for shares of similar public companies and certain benchmarks such as revenues, earnings, earnings before interest and taxes (“EBIT”) and EBITDA, net income or book value.  In valuing the Systems Division, the Company utilized the multiples of market value of capital (“MVC”) divided by revenue and MVC/EBITDA of the selected guideline companies.  These multiples were applied to the System Division’s operating results for the twelve months ended May 31, 2009 in order to derive a fair value under the guideline company approach.

One of the key assumptions in the five-year budgets, which are the basis of the discounted cash flow approach, is the projected revenue growth of each reporting unit.   For each reporting unit, the Company has based its estimate of projected revenue growth on forecasted revenue growth on a macro-level (IT industry and overall US economy) and micro-level (purchasing patterns for specific customers).  For other assumptions in the five-year forecasts, the Company projected gross profit margins at close to historical levels, investments in variable selling and management overhead costs to support revenue growth and increased fixed operating costs at the rate of inflation.  To the extent forecasted revenue is not met for a reporting unit, the Company still has the ability to achieve forecasted profitability (EBITDA) by controlling its cost structure.  Annual revenue growth for each reporting unit is forecasted to be at a higher level in the initial five-year operating forecast and is gradually decreased to the terminal value growth rate for the remaining years under the cash flow approach.

 
7

 
 
Key assumptions in the discounted cash flow approach include the discount rate and terminal growth rate.  The discount rate, which is specific to each reporting unit and is used to determine the present value of future debt-free net cash flow stream, is a blended rate combining required rates of return on debt and equity instruments with comparable risk characteristics. Using such a blended rate appropriately reflects the cost of the debt and equity investment forming the capital of an enterprise, whereas the terminal growth rate at the end of the discrete projection period is determined by using the Constant Growth Valuation Model.  The Constant Growth Valuation Model is based on the assumption that the specific reporting unit will undergo a steady long-term rate of growth in earnings and that the investor purchasing the business has a required rate of return he is willing to accept for his investment.  It assumes a continuing growth in cash flow per annum into perpetuity (consistent with expected real annual growth rate of Gross Domestic Product (“GDP”) plus inflation for the foreseeable future).

The Company examined the sensitivity of the fair values of its Systems Division reporting unit by reviewing other scenarios relative to the initial assumptions it used to see if the resulting impact on fair value would have resulted in a different step one conclusion.  Accordingly, the Company performed sensitivity analyses based on a more conservative annual revenue growth in years 1–5 of the discounted cash flow approach.  In the first sensitivity analysis, the Company lowered the revenue growth in years 1- 5 of the discounted cash flow approach by one-third (holding all other critical assumptions constant), while in the second sensitivity analysis; the Company lowered the revenue growth by two-thirds in years 1–5 of the discounted cash flow approach (holding all other critical assumptions constant).  None of the outcomes of the sensitivity analyses performed impacted the Company’s step one conclusion.  It should be noted that Company did not perform sensitivity analyses on the other reporting units given the relative value of goodwill and the percentage of the reporting unit’s fair value that was in excess of its carrying value.

While the Company has determined the estimated fair values of its reporting units to be appropriate based on the forecasted level of revenue growth, net income and cash flows, in the current market environment it is a reasonable possibility that one of our reporting units may become impaired in future periods as there can be no assurance that the Company’s estimates and assumptions made for purposes of its goodwill impairment testing as of June 1, 2009 will prove to be accurate predictions of the future. Our use of the term "reasonable possibility" refers to a potential occurrence that is more than remote, but less than probable in the Company’s judgment. If the Company’s assumptions, including forecasted revenue growth rates are not achieved, the Company may be required to record goodwill impairment charges in future periods.  Potential events and/or changes in circumstances that could reasonably be expected to negatively impact the key assumptions and affect the recovery of our goodwill include:
 
  
The Company’s revenues are derived from a few major clients, the loss of any of which could cause its results of operations to be adversely affected. A large portion of the Company’s revenues are drawn from various civilian and military U.S. governmental departments and agencies and local school districts. The following factors could have a material negative impact on the Company’s business.
 
o  
seasonality of federal government and education related business makes future financial results less predictable; and
 
o  
due to its dependence on governments and local school districts demand for IT products, a material decline in overall sales to the government as a whole, or to a certain key agency thereof, and/or the education sector could have a material adverse effect on its results of operations.
 
 
8

 
 
●  
The Company’s success in increasing the portion of its revenues derived from IT services and consulting.  If the Company is unsuccessful, it future results may be adversely affected. The Company’s transition from an emphasis on IT product sales to an emphasis on providing IT services and consulting has placed significant demands on its managerial, administrative and operational resources.  The Company’s ability to manage this transition effectively is dependent upon its ability to develop and improve operational, financial, and other internal systems, as well as its business development capabilities, and to attract, train, retain, motivate and manage our employees.  If the Company is unable to do so, it ability to effectively deliver and support its services may be adversely affected.

●  
The Company’s inability to maintain high personnel-utilization rates may adversely impact its profit.  The most significant cost relating to the services component of the Company’s business is personnel expense, which consists of salaries, benefits and payroll related expenses.  Thus, the financial performance of the Company’s service business is based primarily upon billing margins (billable hourly rates less the costs to us of service personnel on an hourly basis) and utilization rates (billable hours divided by paid hours).  The future success of the services component of the Company’s business will depend in large part upon our ability to maintain high utilization rates at profitable billing margins.

●  
The Company’s revenues and expenses are unpredictable. A decrease in revenues or increase in expenses could materially adversely affect its operating results. The Company’s operating results have been, and will continue to be, impacted by changes in technical personnel billing and utilization rates.  Moreover, the Company expects that downward pricing pressure will persist due to the continued commoditization of computer products.  Further, there are numerous other factors, which are not within the Company’s control that can contribute to fluctuations in our operating results, including the following:
 
o  
patterns of capital spending by clients;
 
o  
the timing, size, and mix of product and service orders and deliveries;
 
o  
the timing and size of new projects, including projects for new clients; and
 
o  
changes in trends affecting the outsourcing of IT services.
 
At May 31, 2010, Emtec's market capitalization was greater than its total stockholders' equity. However, the Company’s stock does not trade frequently and thus management believes the inherent value of the Company is not and has not been accurately reflected by the current or historical stock market valuation of the Company.  Accordingly, the Company continues to believe that the income and market-based approaches are the most appropriate valuation methods.
 
In accordance with ASC 350, the Company is performing its annual impairment testing as of June 1, 2010 with the assistance of an external valuation firm. The Company does not currently believe that there is an indication of goodwill impairment at May 31, 2010.  However, if current market conditions change and the Company’s estimated value under the income and market-based approaches is affected, then it is possible that the Company may have to take a goodwill impairment charge against earnings in a future period.

 
9

 

Identifiable Intangible Assets

At May 31, 2010 and August 31, 2009, the components of identifiable intangible assets are as follows (in thousands):
 
   
May 31, 2010
   
August 31, 2009
 
Customer relationships
  $ 14,099     $ 14,098  
Noncompete agreements
    399       398  
Software Technology
    15       -  
Trademarks
    169       169  
Foreign currency translation adjustment
    50       -  
      14,732       14,665  
Accumulated amortization
    (4,655 )     (3,430 )
Foreign currency translation adjustment
    (5 )     -  
Balance, ending
  $ 10,072     $ 11,235  
 
Customer relationships represent the fair value ascribed to customer relationships purchased in 2005, the acquisitions of Luceo and eBAS/Aveeva in fiscal 2008, the acquisition of KOAN-IT in fiscal 2009, and the acquisition of certain assets from SARK  in April 2010 by Emtec India. The amounts ascribed to customer relationships are being amortized on a straight-line basis over 3-15 years.

Noncompete agreements represent the value ascribed to covenants not to compete in employment and acquisition agreements with certain members of Luceo, eBAS/Aveeva and KOAN-IT’s management entered into at the time of the respective acquisitions.  The amounts ascribed to noncompete agreements are being amortized on a straight-line basis over 5 years.

Software technology represents the value ascribed to software developed by SARK, which was acquired by Emtec India in April 2010.

Trademarks represent the value ascribed to trade name and trademarks owned by KOAN-IT and SARK.  The amounts ascribed to trademarks are being amortized on a straight-line basis over 3-5 years.

Amortization expense related to intangible assets was $410,000 and $469,000, for the three months ended May 31, 2010 and 2009, respectively, and $1.2 million and $1.1 million for the nine months ended May 31, 2010 and 2009, respectively.  We currently expect future amortization for the next four years ending August 31, 2010 through 2013 will be approximately $1.6 million per year and for the fiscal year ending 2014 will be approximately $937,000.

Long-lived assets, including customer relationships and property and equipment, are tested for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable in accordance with ASC 350 “Intangibles- Goodwill and Other” and ASC 360 “Property, Plant and Equipment.”  Recoverability of long-lived assets is assessed by a comparison of the carrying amount to the estimated undiscounted future net cash flows expected to result from the use of the assets and their eventual disposition.  If estimated undiscounted future net cash flows are less than the carrying amount, the asset is considered impaired and a loss would be recognized based on the amount by which the carrying value exceeds the fair value of the asset.  No impairment of long-lived assets occurred during nine months ended May 31, 2010 or 2009.
 
 
10

 
 
Foreign Currency Translation and Other Comprehensive Income (loss)

The financial statements of the Company’s foreign subsidiaries are remeasured into U.S. dollars for consolidation and reporting purposes.  The functional currency for the Company’s foreign operations is the local currency.  Current rates of exchange are used to remeasure assets and liabilities.  Adjustments to translate those statements into U.S. dollars are recorded in accumulated other comprehensive income (loss).

The Company’s comprehensive income (in thousands) is presented in the following table:
 
   
For the Three Months Ended May 31,
   
For the Nine Months Ended May 31,
 
   
2010
   
2009
   
2010
   
2009
 
Net Income (loss)
  $ (35 )   $ 273     $ 522     $ 894  
Cumulative translation adjustment, net of taxes
    12       211       66       174  
Total comprehensive income
  $ (23 )   $ 484     $ 588     $ 1,068  
 
Earnings Per Share

Basic earnings per share amounts are computed by dividing net income available to common stockholders (the numerator) by the weighted average shares outstanding (the denominator), during the period. Shares issued during the period are weighted for the portion of the period that they were outstanding.

The computation of diluted earnings per share is similar to the computation of basic earnings per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive options, restricted stock awards and warrants had been exercised as of the end of the period. Potentially dilutive shares consist of stock options, restricted stock awards and warrants totaling 378,916 and 259,041, for the three months ended May 31, 2010 and 2009, respectively, and 187,307 and 254,503 for the nine months ended May 31, 2010 and 2009, respectively. Diluted shares for the three months ended May 31, 2010 were not included in the calculation of diluted net loss per share because the effect of the inclusion would be anti-dilutive. In addition, outstanding warrants to purchase 1,764,437 and 1,688,354 common shares as of and for the periods ended May 31, 2010 and 2009, respectively, were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of the Company’s common shares over those periods.

Income Taxes and Due to Former Stockholders

The Company accounts for income taxes in accordance with ASC 740 "Income Taxes."  The Company files a federal consolidated tax return that includes all U.S. entities.  The Company also files several combined/consolidated state tax returns and several separate state tax returns.  Deferred taxes are provided based upon a review of the tax basis of assets and liabilities, whereby deferred tax assets and liabilities are recognized for temporary differences.  Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis.  Deferred tax assets are recognized for tax loss carryforwards.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.  Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.  Deferred taxes result from timing differences primarily relating to bad debts, inventory reserves, deferred revenue, fixed asset depreciation, compensation expenses and intangible asset amortization.

 
11

 
 
In October 2008, the Company settled the August 2003 and April 2004 tax audits of Emtec Federal, formerly known as Westwood Computer Corporation (“Westwood”), with the Appeals Office of the IRS.  The settlement agreement resulted in an additional federal income tax payment of $145,000, which included interest of $41,000.  The Company has filed 2003 and 2004 amended New Jersey income tax returns to pay additional New Jersey taxes that resulted from the IRS settlement.  The accounting to record the settlements of these pre-merger tax liabilities under ASC 740 resulted in adjustments to goodwill and to deferred tax assets.  Since the Westwood merger agreement included indemnification coverage by Westwood’s former stockholders, the Company recorded a receivable “due from the Westwood former stockholders” of $631,000.  The $631,000 included pre-merger tax liabilities totaling $361,000 plus associated professional fees to defend the Company’s tax positions totaling $270,000.  The $361,000 portion of the Company’s indemnity claim was recorded as a reduction to goodwill acquired in the April 2004 Westwood merger.  The remaining $270,000 portion was recorded as a reduction to selling, general and administrative expenses during the three months ended November 30, 2008.

The “due from Westwood former stockholders” receivable was satisfied during October 2008, based on offsetting amounts “due to Westwood former stockholders” totaling $631,000.  The amounts “due to Westwood former stockholders” represented funds we held as unclaimed merger consideration.

We conduct business nationally and, as a result, file income tax returns in the U.S federal jurisdiction and various state and local jurisdictions. With a few exceptions, we are no longer subject to federal, state or local income tax examinations for tax returns filed for fiscal years 2005 and prior.

Reconciliation of Liabilities for Unrecognized Tax Benefits for the nine months ended May 31, 2010 and 2009 (in thousands) are as follows:
 
Balance at September 1, 2009 and 2008
  $ 202     $ 693  
                 
Unrecognized tax positions of prior periods:
               
     Increase
    -       -  
     Decrease
    -       -  
                 
Unrecognized tax positions of current year:
               
     Increase
    1       13  
     Decrease
    -       -  
                 
Decrease in Unrecognized tax benefits due to settlements
    -       (548 )
                 
Decrease in Unrecognized tax benefits due to lapse of
               
  statute of limitations
    -       -  
                 
Balance at May 31, 2010 and 2009
  $ 203     $ 158  
 
 
12

 
 
   
For the Nine Months Ended,
 
   
May 31, 2010
   
May 31, 2009
 
             
Total amount of unrecognized tax benefits that, if recognized,
 would affect the effective tax rate
  $ 91     $ 57  
                 
Accrued interest and penalties for unrecognized tax benefits
  $ 94     $ 71  
                 
Interest and penalties classified as income tax expense (benefit)
  $ 16     $ (31 )
 
Subsequent Events

On June 4, 2010, Emtec Federal, Secure Data Inc,(“SDI”) and the stockholders of SDI entered into a Stock Purchase Agreement. The Company previously filed details on this acquisition on the Form 8-K, dated June 10, 2010.
 
3.  Stock-Based Compensation
 
Stock Options
 
An amendment to the Company’s 2006 Stock-Based Incentive Compensation Plan (the “2006 Plan”) was approved by the Company’s stockholders on February 2, 2009. The 2006 Plan authorizes the granting of stock options to directors and eligible employees. The amendment increased the aggregate number of shares of Common Stock available under the 2006 Plan from 1,400,000 shares to 2,543,207 shares eligible for issuance at prices not less than 100% of the fair value of the Company’s common stock on the date of grant (110% in the case of stockholders owning more than 10% of the Company’s common stock). Options under the 2006 Plan have terms from 7 to 10 years and certain options vest immediately and others through a term up to 4-5 years.
 
The Company measures the fair value of options on the grant date using the Black-Scholes option valuation model.  The Company estimated the expected volatility using the Company’s historical stock price data over the expected term of the stock options.  The Company also used historical exercise patterns and forfeiture behaviors to estimate the options, expected term and our forfeiture rate.  The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve in effect on the grant date.  Both expected volatility and the risk-free interest rate are based on a period that approximates the expected term.
 
A summary of stock options for the nine months ended May 31, 2010 is as follows:
 
For the Nine Months Ended May 31, 2010
 
Shares
   
Weighted Average Exercise Price
 
Weighted Average Remaining Term
 
Aggregate Intrinsic Value *
 
Options Outstanding -September 1, 2009
  359,500     $1.15          
Options Granted
  75,833     $1.12          
Options Exercised
  -     -          
Options Forfeited or Expired
  (22,000 )   $1.31          
Options Outstanding - May 31, 2010
  413,333     $1.13  
5.96 years
    $44,808  
Options Exercisable - May 31, 2010
  323,808     $1.13  
6.10 years
    $44,808  

* Represents the total pre-tax intrinsic value based on the Company’s average closing stock prices for the nine months ended May 31, 2010.
 
 
13

 
 
There were no stock options issued during the three months ended November 30, 2009; 13,333 stock options were issued during the three months ended February 28, 2010; and 62,500 stock options were issued during the three months ended May 31, 2010. The following assumptions were used to value stock options issued during the three months ended February 28, 2010 and May 31, 2010:
 
   
2010
Weighted-Average Fair Value
                     0.84
Assumptions
   
Expected Volatility
 
87.86% - 88.07%
Expected Term
 
5 - 6.5  years
Expected Forfeiture Rate
 
0%
Dividend Yield
 
0%
Risk-Free Interest Rate
 
2.01% - 2.09%
 
Nonvested Stock (Restricted Stock)
 
The following table summarizes the Company’s restricted stock activity during the nine months ended May 31, 2010:
 
For the Nine Months Ended May 31, 2010
 
Shares
   
Weighted Average Grant Date Fair Value
   
Fair Value
   
Nonvested - September 1, 2009
  565,859     $0.72          
Granted
  684,841     $1.08          
Vested
  (432,284 )   $0.72     $ 445,076  
(a)
Forfeited
  -     -            
Nonvested - May 31, 2010
  818,416     $1.03     $ 1,145,782  
(b)
 
(a)  
The fair value of vested restricted stock shares represents the total pre-tax fair value, based on the closing stock price on the day of vesting, which would have been received by holders of restricted stock shares had all such holders sold their underlying shares on that date.
 
(b)  
The aggregate fair value of the nonvested restricted stock shares expected to vest represents the total pre-tax fair value, based on the Company’s closing stock price as of May 31,  2010 which would have been received by holders of restricted stock shares had all such holders sold their underlying shares on that date.
 
The Company recognizes compensation expense associated with the issuance of such shares using the closing price of the Company’s common stock on the Over-the-Counter Bulletin Board on the date of grant over the vesting period on a straight-line basis.
 
Stock Options and Nonvested Stock
 
Stock-based compensation costs related to the 2006 Plan totaled $118,000 and $3,000 for the three months ended May 31, 2010 and 2009, respectively, and $393,000 and $87,000 for the nine months ended May 31, 2010 and 2009, respectively.  As of May 31, 2010, the Company had $601,000 of unrecognized compensation cost related to the 2006 Plan.  The unrecognized compensation cost is expected to be recognized over a remaining period of 3 years.
 
 
14

 

4.  Warrants
 
On August 5, 2005, the Company issued certain stockholders stock warrants that evidence the obligation of the Company to issue a variable number of shares, in the aggregate, equal to 10% of then total issued and outstanding shares of the Company’s common stock, measured on a post-exercise basis, at any date during the 5-year term of the warrants, which ends August 5, 2010.  The aggregate exercise price of these warrants is fixed at $3.7 million. The exercise price per warrant will vary based upon the number of shares issuable under the warrants. The number of shares issuable under the warrants totaled 1,764,437 and 1,688,354 shares, with an exercise price of $2.09 and $2.19 per share, as of May 31, 2010 and 2009, respectively. The outstanding warrants were anti-dilutive for the nine months ended May 31, 2010 and 2009 because the exercise price was greater than the average market price of the Company’s common shares.
 
Effective as of September 1, 2009, the Company adopted FASB Accounting Standards Codification, which includes the applicable authoritative literature relating to the recording and disclosure of warrants, formerly included in EITF 07-05, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock.” The adoption of these standards related to the above mentioned warrants was not recorded in the financial statements because the Company determined that the impact was not material at the adoption date as of September 1, 2009 and subsequent reporting periods.
 
5.  Line of Credit
 
The Company, Emtec NJ, Emtec LLC, Emtec Federal, Emtec Global, Luceo, eBAS, and Aveeva (collectively, the “Borrower”), have a Loan and Security Agreement with De Lage Landen Financial Services, Inc. (the “Lender”) pursuant to which the Lender provides the Borrower with a revolving credit loan and floor plan loan (the “Credit Facility”). The Credit Facility provides for aggregate borrowings of the lesser of $32.0 million or 85% of Borrower’s eligible accounts receivable, plus 100% of unsold inventory financed by the Lender. The floor plan loan portion of the Credit Facility is for the purchase of inventory from approved vendors and for other business purposes. The Credit Facility subjects the Borrower to mandatory repayments upon the occurrence of certain events as set forth in the Credit Facility.
 
On December 5, 2008, the Borrower entered into a First Amendment and Joinder to Loan and Security Agreement and Schedule to Loan and Security Agreement (the “First Amendment”) with the Lender, pursuant to which the Lender extended the term of the loans issued to the Borrower under the Loan and Security Agreement from December 7, 2008 until December 7, 2010 and made certain other amendments to the Loan and Security Agreement, including the following:
 
§  
The First Amendment changed the base rate of interest to the three month (90 day) LIBOR rate from the previous base rate of the “Prime Rate.”

§  
The First Amendment changed the interest rate for revolving credit loans to the base rate plus 3.25% from the previous interest rate for revolving credit loans which was the base rate minus 0.5%, and changed the interest rate for floorplan loans, if applicable, to 6.25% in excess of the base rate from the previous interest rate for floorplan loans of 2.5% in excess of the base rate.

§  
The First Amendment amended the Schedule to provide that the Borrower must pay the Lender a floorplan annual volume commitment fee if the aggregate amount of all floorplan loans does not equal or exceed $60.0 million in a 12-month period from December 1st through November 30th.  The floorplan commitment fee is equal to the amount that the floorplan usage during such 12-month period is less than $60.0 million multiplied by 1%.  If the Borrower terminates the Credit Facility during a 12-month period, the Borrower shall be required to pay the Lender a prorated portion of the annual volume commitment fee.
 
 
15

 
 
The Company had balances of $13.8 million and $9.0 million outstanding under the revolving portion of the Credit Facility, and balances of $2.8 million and $5.4 million (included in the Company’s accounts payable) outstanding plus $1.3 million and $321,000 in open approvals under the floor plan portion of the Credit Facility at May 31, 2010 and August 31, 2009, respectively. Net availability was $5.2 million and $11.9 million under the revolving portion of the Credit Facility, and additionally $8.8 million and $5.4 million was available under the floor plan portion of the Credit Facility as of May 31, 2010 and August 31, 2009, respectively.
As of May 31, 2010, the Company determined that it was in compliance with its financial covenants under the Credit Facility.

6.  Concentration of Credit Risk
 
Financial instruments that potentially subject the Company to a concentration of credit risk consist principally of accounts receivable.
 
The Company’s revenues, by client type, consist of the following (in thousands):
 
   
For the Three Months Ended
 
   
May 31, 2010
   
May 31, 2009
 
Departments of the U.S. Government
  $ 22,457       42.0 %   $ 11,720       23.8 %
Canadian Government Agencies
    760       1.4 %     619       1.2 %
State and Local Governments
    1,026       1.9 %     1,217       2.5 %
Commercial Companies
    12,977       24.3 %     15,556       31.6 %
Education and other
    16,287       30.4 %     20,107       40.9 %
Total Revenues
  $ 53,506       100.0 %   $ 49,219       100.0 %
 
   
For the Nine Months Ended
 
   
May 31, 2010
   
May 31, 2009
 
Departments of the U.S. Government
  $ 79,373       48.6 %   $ 63,160       39.3 %
Canadian Government Agencies
    1,480       0.9 %     620       0.4 %
State and Local Governments
    3,162       1.9 %     6,162       3.8 %
Commercial Companies
    38,462       23.7 %     50,294       31.1 %
Education and other
    40,710       24.9 %     40,964       25.4 %
Total Revenues
  $ 163,187       100.0 %   $ 161,200       100.0 %
 
The Company reviews a client's credit history before extending credit.  The Company does not require collateral or other security to support credit sales. The Company provides an allowance for doubtful accounts based on the credit risk of specific clients, historical experience and other identified risks. Trade receivables are carried at original invoice less an estimate made for doubtful receivables, based on review by management of all outstanding amounts on a periodic basis.  Trade receivables are considered delinquent when payment is not received within standard terms of sale, and are charged-off against the allowance for doubtful accounts when management determines that recovery is unlikely and ceases its collection efforts.

 
16

 
 
The trade account receivables consist of the following (in thousands):
 
   
May 31,
   
August 31,
 
   
2010
   
2009
 
Trade receivables
  $ 32,949     $ 29,767  
Allowance for doubtful accounts
    (482 )     (304 )
Trade receivables, net
  $ 32,467     $ 29,463  
 
Trade receivables included $1.5 million of unbilled revenue as of May 31, 2010 and August 31, 2009.

Major Customers

Sales to two school districts accounted for approximately $11.1 million or 20.7%, and $5.8 million or 10.9% of the Company’s total revenues for the three months ended May 31, 2010. The same customers accounted for approximately $13.8 million or 28.1%, and $6.3 million or 12.7% of the Company’s total revenue for the three months ended May 31, 2009.
 
Sales to one school district accounted for approximately $26.7 million or 16.4% of the Company’s total revenues for the nine months ended May 31, 2010. The same customers accounted for approximately $27.0 million or 16.8% of the Company’s total revenue for the nine months ended May 31, 2009.

Trade receivables due from two school districts accounted for approximately 17.9% and 14.9%, respectively, of the Company’s trade receivables as of May 31, 2010. The same clients accounted for approximately 14.4% and 17.8%, respectively of the Company’s trade receivables as of August 31, 2009.

7.  Accrued Liabilities
 
At May 31, 2010 and August 31, 2009, accrued liabilities consisted of the following (in thousands):
 
   
May 31, 2010
   
August 31, 2009
 
Accrued payroll
  $ 2,063     $ 2,559  
Accrued commissions
    418       586  
Accrued state sales taxes
    72       74  
Accrued third-party service fees
    101       72  
Other accrued expenses
    2,989       3,432  
    $ 5,643     $ 6,723  
 
 
17

 
 
8.  Long-Term Debt
 
At May 31, 2010 and August 31, 2009, the Company’s long-term debt consisted of the following (in thousands):
 
   
May 31,
   
August 31,
 
   
2010
   
2009
 
             
5% subordinated note payable to DARR Global Holdings, Inc.
  $ 82     $ 345  
8% subordinated note payable to Mr. Siva Natarajan
    -       410  
6% subordinated note payable to Former Shareholders of KOAN-IT
    -       458  
Total debt
    82       1,213  
Less current portion
    (82 )     (1,213 )
Long-term debt, net of current portion
  $ -     $ -  
 
9.  Related Party Transactions

One of the Company’s facilities is leased under a non-cancelable operating lease agreement with an entity that is owned by a former director and current officer of the Company and their related family members. During the three months ended May 31, 2010 and 2009, the Company recorded expense under this lease totaling $52,000 and $47,000, respectively. During the nine months ended May 31, 2010 and 2009, the Company recorded expense under this lease totaling $155,000 and $137,000, respectively. The facilities consist of office and warehouse space totaling 42,480 square feet located in Springfield, New Jersey.
 
The Company occupies approximately 36,000 square feet of office and warehouse space in a 70,000 square-foot building in Suwannee, GA. This space is leased from GS&T Properties, LLC, in which an officer of the Company is a passive investor with an approximately 10% equity interest. The current lease term is through November 2014 with monthly rent of $21,000. During the three months ended May 31, 2010 and 2009, the Company recorded expense under this lease totaling $50,000 and $47,000, respectively. During the nine months ended May 31, 2010 and 2009, the Company recorded expense under this lease totaling $150,000 and $142,000, respectively.

In conjunction with the acquisition of eBAS/Aveeva, the Company entered into a lease for approximately 20,000 square feet of office space in Fremont, California.  This space is leased from the spouse of an officer of eBAS/Aveeva.  The lease term is through August 31, 2011 with a monthly rent of $20,000. In March 2009, the Company subleased a portion of the building for a monthly rent of $3,000 on a month-to-month basis, which was terminated effective February 1, 2010. During the three months ended May 31, 2010 and 2009, the Company recorded expense under this lease totaling $60,000 and $53,000, respectively. During the nine months ended May 31, 2010 and 2009, the Company recorded expense under this lease totaling $168,000 and $173,000, respectively.

In conjunction with the acquisition of certain assets from SARK,  Emtec India entered into a lease for approximately 3,100 square feet of office space in Mumbai, India.  This space is leased from former shareholders of SARK, who are currently members of the management team of Emtec India.  The lease term is through February 2011 with a monthly rent of approximately $3,200. During the three months ended May 31, 2010, the Company recorded expense under this lease totaling of $6,400.

Management believes the lease payments referenced above are at or below market lease rates for similar facilities.

 
18

 
 
10.      Legal Proceedings

In December 2007, the Company received a subpoena issued by the GSA Office of Inspector General ("OIG"), apparently as part of an ongoing, industry-wide investigation.  The Company produced documents and data in response to the subpoena to the OIG during 2008.  In September 2009, the Company, along with several other prominent IT companies, was served with a qui tam lawsuit entitled Christopher Crennen, et al. v. Dell Marketing, et al., which was filed in the United States District Court for the District of Massachusetts.  The lawsuit alleged violations of the False Claims Act relating to the Company's obligations under the Buy American Act and the Trade Agreements Act.   The Company filed a motion to dismiss the lawsuit on November 13, 2009, on the grounds that the amended complaint failed to comply with Rules 9(b) and 12(b)(6) of the Federal Rules of Civil Procedure.  On April 27, 2010, the District Court granted the motion and dismissed the amended complaint with prejudice.  The relator did not file a notice of appeal and, as such, the case is closed. 
 
11.      Segment Information

The Company provides segment financial information in accordance with ASC 280, “Segment Reporting.”  The Company’s business activities are divided into two business segments, EIS and EGS. EIS consists of the Systems Division, which includes Emtec NJ, Emtec LLC, Emtec Federal and the business service management solutions offered by the ITSM practice. EGS is the Company’s enterprise applications services solutions and training business including its ERP and Application Development practice and its Business Analysis and Quality Assurance Practice and its Software Development practice.  The accounting policies of our segments are the same as those described in Note 2 and there are no material intersegment transactions. Summarized financial information relating to the Company’s operating segments is as follows (in thousands):
 
   
(Unaudited)
       
   
May 31,
2010
   
August 31,
2009
 
Identifiable Assets:
           
   EIS
  $ 54,889     $ 51,586  
   EGS
    13,356       13,687  
Total Assets
  $ 68,245     $ 65,273  
 
 
19

 
 
   
For the Three Months Ended
   
For the Nine Months Ended
 
   
May 31,
   
May 31,
 
   
(Unaudited)
   
(Unaudited)
 
   
2010
   
2009
   
2010
   
2009
 
Revenues
                       
  EIS
  $ 45,791     $ 40,534     $ 140,800     $ 133,137  
  EGS
    7,715       8,685       22,387       28,063  
Total Revenue
  $ 53,506     $ 49,219     $ 163,187     $ 161,200  
                                 
Gross Profit
                               
  EIS
  $ 6,736     $ 6,199     $ 20,619     $ 17,398  
  EGS
    1,345       1,447       3,910       5,169  
Gross Profit
  $ 8,081     $ 7,646     $ 24,529     $ 22,567  
                                 
Depreciation and amortization
                               
  EIS
  $ 371     $ 410     $ 1,082     $ 1,085  
  EGS
    180       222       636       649  
Depreciation and amortization
  $ 551     $ 632     $ 1,718     $ 1,734  
                                 
Operating Income (loss)
                               
  EIS
  $ 371     $ 581     $ 1,609     $ 1,149  
  EGS
    (246 )     88       (233 )     1,098  
Operating Income (loss)
  $ 125     $ 669     $ 1,376     $ 2,247  
                                 
Interest and Other Expense (Income)
                               
  EIS
  $ 66     $ 99     $ 238     $ 390  
  EGS
    51       82       160       308  
Interest and Other Expense (Income)
  $ 117     $ 181     $ 398     $ 698  
                                 
Provision for Income Taxes
                               
  EIS
  $ 138     $ 199     $ 573     $ 306  
  EGS
    (95 )     16       (117 )     349  
Provision for Income Taxes
  $ 43     $ 215     $ 456     $ 655  
                                 
Net Income (loss)
                               
  EIS
  $ 167     $ 283     $ 798     $ 453  
  EGS
    (202 )     (10 )     (276 )     441  
Net Income (loss)
  $ (35 )   $ 273     $ 522     $ 894  
                                 
Capital expenditures
                               
  EIS
  $ 296     $ 482     $ 502     $ 761  
  EGS
    16       2       61       34  
Capital expenditures
  $ 312     $ 484     $ 563     $ 795  
                                 
 

 
20

 

Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis should be read in conjunction with, and is qualified in its entirety by, the unaudited financial statements, including the notes thereto, appearing elsewhere in this Quarterly Report on Form 10-Q.
 
Cautionary Statement Regarding Forward-Looking Statements
 
You should carefully review the information contained in this Quarterly Report on Form 10-Q and in other reports or documents that we file from time to time with the Securities and Exchange Commission (the “SEC”).  In addition to historical information, this Quarterly Report on Form 10-Q contains our beliefs regarding future events and our future financial performance.  In some cases, you can identify those so-called “forward-looking statements” by words such as “may,” “will,” “should,” expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of those words and other comparable words.  You should be aware that those statements are only our predictions.  Actual events or results may differ materially.  We undertake no obligation to publicly release any revisions to forward-looking statements after the date of this report. In evaluating those statements, you should specifically consider various factors, including the risk factors discussed in our Annual Report on Form 10-K for the year ended August 31, 2009 and other reports or documents that we file from time to time with the SEC.  All forward-looking statements attributable to us or a person acting on our behalf are expressly qualified in their entirety by this cautionary statement.
 
Assumptions relating to budgeting, marketing, and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our marketing, capital expenditure or other budgets, which may in turn affect our business, financial position, results of operations and cash flows.
 
Overview of Emtec
 
We are a systems integrator providing IT services and products to the federal, state and local government, education and commercial markets. We help our clients identify and prioritize areas for improvement and then implement process, technology and business application improvements that reduce costs, improve service and align the delivery of IT with the needs of their organizations. Our value based management methods, coupled with IT technology, consulting and development services, allow us to address a wide range of specific client needs, as well as support broader IT transformation initiatives.  Our client base is comprised of departments of federal, state and local governments in the United States and Canada and schools and commercial businesses throughout the United States and Canada.

On a consolidated basis for the three months ended May 31, 2010, our total revenue increased by $4.3 million or 8.7%, our gross profit increased by $435,000 or 5.7% and our operating income decreased by $544,000, compared with the three months ended May 31, 2009.  For the nine months ended May 31, 2010, our total revenue increased by $2.0 million or 1.2%, our gross profit increased by $2.0 million or 8.7% and our operating income decreased by $871,000.  This decrease is mainly due to decreases in our commercial and state and local government business. In 2009, we embarked upon cost cutting initiatives to stabilize the profitability of our business and to focus more on selling services.  While our sales into federal and education clients have continued to improve, our commercial and state and local government business has declined due to a slow economic recovery which has prevented us  from attracting new profitable customers, who purchase procurement services.

 
21

 
 
Management’s analysis concluded that we were profitable in the commercial and state and local government business only when customers were of sufficient scale in purchasing procurement services. Management also analyzed the impact of investing in this business and concluded that investment in growth should be focused on our consulting services in the commercial sector.  Since our analysis showed that the current level of gross profit from this sector is insufficient to cover the costs of the selling general and administrative expenses  for the sector management reduced expenses in April of 2010. From April 2010 thru June 2010, the Company eliminated approximately $2.1 million in annualized costs as a result of this restructuring. Management is now focusing its efforts on attracting talent to our higher gross margin consulting practices in the commercial sector, which may increase our costs in servicing commercial clients in the future. In addition, the Company continues to invest in new growth initiatives, including the executive management team, professional recruiting fees, and merger and acquisition expenses. We intend for our investments to increase higher margin services and consulting revenues and  improve our profitability in future quarters.

Our gross profit can be impacted by various factors including changes in mix of products and services sold, changes in technical employee utilization rates, changes in the billing rates, the mix of client type and the decision to aggressively price certain products and services.

Factors that may in the future have a negative impact on our selling, general and administrative expenses for both divisions include costs associated with marketing and selling activities, potential merger and acquisition related costs, technological improvement costs, compliance costs associated with SEC rules and increases in our insurance costs.

We have divided our operating activity into two operating segments for reporting purposes: EIS and EGS. EIS consists of the Company’s historical business, which we refer to as the Systems Division, and the business service management solutions offered by the ITSM practice. EGS is the Company’s enterprise applications services solutions and training business including its ERP and Application Development practice and its Business Analysis and Quality Assurance Practice. As our business evolves, including based on our recent experience with cross selling services between these two divisions, we will continue to reassess our segment reporting structure in accordance with ASC 280, “Segment Reporting.”

 
22

 

Consolidated Statements of Operations for the Three Months Ended May 31, 2010 compared with the Three Months Ended May 31, 2009.
 
EMTEC, INC.
 
CONSOLIDATED STATEMENTS OF INCOME
 
(In thousands)
 
                   
   
Three Months Ended May 31,
             
   
2010
   
2009
   
Change
   
%
 
Revenues
                       
Procurement services
  $ 39,536     $ 35,321     $ 4,215       11.9 %
Service and consulting
    13,970       13,898       72       0.5 %
Total Revenues
    53,506       49,219       4,287       8.7 %
                                 
Cost of Sales
                               
Cost of procurement services
    35,140       31,204       3,936       12.6 %
Service and consulting
    10,285       10,369       (84 )     (0.8 )%
Total Cost of Sales
    45,425       41,573       3,852       9.3 %
                                 
Gross Profit
                               
Procurement services
    4,396       4,117       279       6.8 %
Procurement services %
    11.1 %     11.7 %                
                                 
Service and consulting
    3,685       3,529       156       4.4 %
Service and consulting %
    26.4 %     25.4 %                
                                 
Total Gross Profit
    8,081       7,646       435       5.7 %
Total Gross Profit %
    15.1 %     15.5 %                
                                 
Operating expenses:
                               
Selling, general, and administrative expenses
    7,243       6,198       1,045       16.9 %
Rent expense – related party
    162       147       15       10.2 %
Depreciation and amortization
    551       632       (81 )     (12.8 )%
Total operating expenses
    7,956       6,977       979       14.0 %
Percent of revenues
    14.9 %     14.2 %                
                                 
Operating income
    125       669       (544 )     (81.3 )%
Percent of revenues
    0.2 %     1.4 %                
                                 
Other expense (income):
                               
Interest income – other
    (3 )     (5 )     2       40.0 %
Interest expense
    124       169       (45 )     (26.6 )%
Other
    (4 )     17       (21 )     (123.5 )%
                                 
Income before income taxes
    8       488       (480 )     (98.4 )%
Provision (benefit) for income taxes
    43       215       (172 )     (80.0 )%
Net income (loss)
  $ (35 )   $ 273     $ (308 )     (112.8 )%
Percent of revenues
    -0.1 %     0.6 %                
 
We currently categorize our revenues and costs of sales into “Procurement Services” and “Services and Consulting.”  We have made the categorizations in order to analyze our growth in consulting and other services as a percentage of our overall revenues.  We have divided our business into two segments.  EIS provides a broad range of IT infrastructure services for our clients.  These services are focused on improving the value IT assets provide to an organization, and to reduce the costs of these assets.  EGS was formed to provide IT application consulting and other services.  These services typically include business process improvement through the use of technology.  Our consultants are skilled in a wide array of technologies in this segment.

 
23

 
 
We discuss the results of each segment below.

Results of Operations -EIS

EIS serves departments of the U.S. government, Canadian government agencies, state and local governments, education markets and commercial companies.

The following discussion and analysis provides information that management believes is relevant to an assessment and understanding of our EIS Results of Operations for the three months ended  May 31, 2010 and 2009.
 
EIS
 
STATEMENTS OF INCOME
 
(In thousands)
 
                   
   
Three Months Ended May 31,
             
   
2010
   
2009
   
Change
   
%
 
Revenues
                       
Procurement services
  $ 39,536     $ 35,321     $ 4,215       11.9 %
Service and consulting
    6,255       5,213       1,042       20.0 %
Total Revenues
    45,791       40,534       5,257       13.0 %
                                 
Cost of Sales
                               
Cost of procurement services
    35,140       31,204       3,936       12.6 %
Service and consulting
    3,915       3,131       784       25.0 %
Total Cost of Sales
    39,055       34,335       4,720       13.7 %
                                 
Gross Profit
                               
Procurement services
    4,396       4,117       279       6.8 %
Procurement services %
    11.1 %     11.7 %                
                                 
Service and consulting
    2,340       2,082       258       12.4 %
Service and consulting %
    37.4 %     39.9 %                
                                 
Total Gross Profit
    6,736       6,199       537       8.7 %
Total Gross Profit %
    14.7 %     15.3 %                
                                 
Operating expenses:
                               
Selling, general, and administrative expenses
    5,892       5,113       779       15.2 %
Rent expense – related party
    102       95       7       7.4 %
Depreciation and amortization
    371       410       (39 )     (9.5 )%
Total operating expenses
    6,365       5,618       747       13.3 %
Percent of revenues
    13.9 %     13.9 %                
                                 
Operating income
    371       581       (210 )     (36.1 )%
Percent of revenues
    0.8 %     1.4 %                
                                 
Other expense (income):
                               
Interest income – other