U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDING JUNE 30, 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: 333-84045
PREDICTIVE SYSTEMS, INC.
(Exact Name of Registrant as Specified in its Charter)
DELAWARE 13-3808483
---------------------------------- ---------------------------------------
(State or other Jurisdiction of (I.R.S. Employer Identification Number)
Incorporation or Organization)
19 WEST 44TH STREET, NEW YORK, NEW YORK 10036
(Address of Principal Executive Offices) (Zip Code)
(212) 659-3400
(Registrant's Telephone Number, Including Area Code)
Check whether the registrant: (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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 [ ]
As of August 13, 2002, there were 37,368,012 shares of the registrant's common
stock, $.001 par value per share, outstanding.
INDEX
PREDICTIVE SYSTEMS, INC.
Page
----
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Balance Sheets as of June 30, 2002
(unaudited) and December 31, 2001 ........................ 1
Consolidated Statements of Operations for the three and
six months ended June 30, 2002 (unaudited) and 2001
(unaudited)............................................... 2
Consolidated Statements of Cash Flows for the three and
six months ended June 30, 2002 (unaudited) and 2001
(unaudited)............................................... 3
Notes to Consolidated Financial Statements (unaudited) ... 4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS ..................... 7
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK .................................................... 16
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS ........................................ 17
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS ................ 17
ITEM 3. DEFAULTS UPON SENIOR SECURITIES .......................... 17
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ...... 17
ITEM 5. OTHER INFORMATION ........................................ 17
ITEM 6. EXHIBITS AND REPORT ON FORM 8-K .......................... 17
ITEM 7. SIGNATURES ............................................... 18
PART 1. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
June 30, 2002 December 31, 2001
------------- -----------------
(unaudited)
ASSETS
Current assets
Cash and cash equivalents ............................................................... $ 23,342,138 $ 41,277,867
Accounts receivable - net of allowance for
doubtful accounts of $1,945,676 and $2,606,361, respectively ....................... 8,891,581 10,124,399
Related party receivables ............................................................... 1,343,676 1,052,540
Unbilled work in process ................................................................ 1,168,708 1,319,044
Inventory held for resale ............................................................... 213,068 2,205,986
Receivables from employees and stockholders ............................................. 29,440 61,526
Refundable income taxes ................................................................. 364,027 375,982
Prepaid expenses and other current assets ............................................... 1,895,165 2,180,531
------------- -------------
Total current assets ............................................................... 37,247,803 58,597,875
Property and equipment - net of accumulated
depreciation and amortization of $791,254 and $4,587,357, respectively .................. 619,078 6,323,100
Intangible assets - net of accumulated amortization of $2,032,293 and $25,171,316, respectively . 2,231,251 36,242,922
Restricted cash ................................................................................. 1,341,713 782,292
Other assets .................................................................................... 468,255 547,103
------------- -------------
Total assets ............................................................. $ 41,908,100 $ 102,493,292
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable ........................................................................ $ 1,691,167 $ 5,451,745
Accrued expenses and other current liabilities .......................................... 10,045,324 11,469,090
Current portion of capital lease obligations ............................................ 66,455 81,714
Deferred income ......................................................................... 582,497 333,527
------------- -------------
Total current liabilities .......................................................... 12,385,443 17,336,076
------------- -------------
Noncurrent liabilities
Capital lease obligations ............................................................... 22,455 52,134
Deferred rent ........................................................................... 233,289 165,251
Other long-term liabilities ............................................................. 3,000 3,000
------------- -------------
Total noncurrent liabilities ....................................................... 258,744 220,385
------------- -------------
Total liabilities .................................................................. 12,644,187 17,556,461
------------- -------------
Commitments and contingencies
Stockholders' equity
Common stock, $.001 par value, 200,000,000 shares authorized,
37,368,261 and 36,360,491 shares issued and outstanding, respectively .............. 37,368 36,361
Additional paid-in capital .............................................................. 230,329,387 229,408,586
Deferred compensation ................................................................... (93,414) (182,581)
Accumulated deficit ..................................................................... (201,298,633) (144,390,718)
Accumulated other comprehensive income .................................................. 289,205 65,183
------------- -------------
Total stockholders' equity ......................................................... 29,263,913 84,936,831
------------- -------------
Total liabilities and stockholders' equity ............................... $ 41,908,100 $ 102,493,292
============= =============
The accompanying notes are an integral part of these consolidated
financial statements.
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended June 30 Six Months Ended June 30
----------------------------- -----------------------------
2002 2001 2002 2001
------------ ------------ ------------ ------------
Revenues:
Professional services .................................. $ 11,556,018 $ 17,841,371 $ 25,661,941 $ 38,199,215
Reimbursed expenses .................................... 322,566 550,176 723,727 1,130,682
Hardware and software sales ............................ 79,303 491,831 602,786 892,911
------------ ------------ ------------ ------------
Total revenues .................................... 11,957,887 18,883,378 26,988,454 40,222,808
------------ ------------ ------------ ------------
Cost of revenues (excluding noncash compensation
expense of $16,875, $48,605,
$35,845 and $101,289, respectively):
Professional services .................................. 8,894,601 12,974,482 19,065,937 28,302,022
Costs of reimbursed expenses ........................... 322,566 550,176 723,727 1,130,682
Hardware and software purchases ........................ 63,728 896,031 556,887 1,178,859
------------ ------------ ------------ ------------
Total cost of revenues ............................ 9,280,895 14,420,689 20,346,551 30,611,563
------------ ------------ ------------ ------------
Gross profit ...................................... 2,676,992 4,462,689 6,641,903 9,611,245
------------ ------------ ------------ ------------
Sales and marketing (excluding noncash compensation
expense of $7,840, $35,243, $11,458
and $69,623, respectively) ................................... 2,232,146 4,729,089 4,974,197 9,288,641
General and administrative (excluding noncash
compensation expense of $12,839, $24,121, $25,870
and $47,324, respectively) ................................... 6,498,730 11,947,772 12,939,768 23,716,103
Depreciation and amortization .................................. 732,383 953,284 1,506,785 1,719,779
Intangibles amortization ....................................... 980,250 6,300,112 1,960,500 12,674,891
Impairment of intangibles ...................................... 8,743,545 - 8,743,545 -
Impairment of property and equipment ........................... 4,510,193 - 4,510,193 -
Restructuring and other charges ................................ 3,303,102 3,663,817 4,236,604 4,304,765
Loss on long-term investment in related party .................. - - - 1,000,000
Noncash compensation expense ................................... 37,554 107,969 73,173 218,236
------------ ------------ ------------ ------------
Operating expenses ................................ 27,037,903 27,702,043 38,944,765 52,922,415
------------ ------------ ------------ ------------
Operating loss .................................... (24,360,911) (23,239,354) (32,302,862) (43,311,170)
Other income (expense):
Interest income, net ................................... 107,389 668,659 242,637 1,731,683
Other expense, net ..................................... (1,094,496) (75,669) (1,540,064) (53,784)
------------ ------------ ------------ ------------
Loss before cumulative effect of change in
accounting principle ......................................... (25,348,018) (22,646,364) (33,600,289) (41,633,271)
Cumulative effect of change in accounting principle ............ - - (23,307,626) -
------------ ------------ ------------ ------------
Net loss ....................................................... $(25,348,018) $(22,646,364) $(56,907,915) $(41,633,271)
============ ============ ============ ============
Basic and diluted loss per common share before
cumulative effect of change in accounting principle .......... $ (0.68) $ (0.63) $ (0.90) $ (1.17)
Cumulative effect of change in accounting principle ............ - - (0.63) -
------------ ------------ ------------ ------------
Basic and diluted net loss per common share .................... $ (0.68) $ (0.63) $ (1.53) $ (1.17)
============ ============ ============ ============
Basic and diluted weighted average common
shares outstanding ........................................... 37,336,755 35,952,843 37,162,460 35,697,095
============ ============ ============ ============
The accompanying notes are an integral part of these consolidated
financial statements.
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Six Months Ended June 30
--------------------------------------
2002 2001
------------- --------------
Cash flows from operating activities:
Net loss $ (56,907,915) $ (41,633,271)
Adjustments to reconcile net loss to net cash used in operating activities:
Noncash compensation expense 73,173 218,236
Depreciation and amortization 3,467,285 14,394,670
Impairment of intangibles 8,743,545 -
Impairment of property and equipment 4,510,193 -
Cumulative effect of change in accounting principle 23,307,626 -
Bad debt expense 10,257 1,434,179
Loss on long-term investment in related party - 1,000,000
Write-off of inventory held for resale 1,527,168 500,000
Noncash component of restructuring and other charges 497,319 1,231,050
(Increase) decrease in-
Restricted cash (559,421) -
Accounts receivable 931,425 4,897,996
Unbilled work in process 150,336 1,205,070
Inventory held for resale 465,750 (3,500,000)
Refundable income taxes 11,955 (335,085)
Prepaid expenses and other current assets 285,367 (1,549,768)
Other assets 78,847 (101,603)
(Decrease) increase in-
Accounts payable (3,760,579) 823,621
Accrued expenses and other current liabilities (1,423,764) 3,031,527
Deferred income 248,970 995,016
Deferred rent and other long-term liabilities 68,038 8,635
------------- -------------
Net cash used in operating activities (18,274,425) (17,379,727)
------------- -------------
Cash flows from investing activities:
Purchase of marketable securities, net (2,158) 1,797,802
Repayments (proceeds) from employee loans, net 22,334 (537)
Adjustments to purchase price for fiscal 2000 acquisitions - (1,961,302)
Purchase of property and equipment, net (810,276) (5,118,216)
------------- -------------
Net cash used in investing activities (790,100) (5,282,253)
------------- -------------
Cash flows from financing activities:
Principal payments on capital leases (44,938) (91,167)
Proceeds from issuance of common stock in connection with
Employee Stock Purchase Plan 57,513 204,312
Proceeds from exercise of stock options 890,041 1,625,774
------------- -------------
Net cash provided by financing activities 902,616 1,738,919
------------- -------------
Effects of exchange rates 226,180 (183,117)
------------- -------------
Net decrease in cash (17,935,729) (21,106,178)
Cash and cash equivalents - beginning of period 41,277,867 80,058,791
------------- -------------
Cash and cash equivalents - end of period $ 23,342,138 $ 58,952,613
============= =============
Supplemental disclosures of cash flow information: Cash paid during the
year for:
Interest $ 23,340 $ 23,251
============= =============
Taxes $ 112,282 $ 280,349
============= =============
Supplemental disclosures on noncash investing and financing activities:
Noncash adjustment to purchase price for fiscal 2000 acquisitions $ - $ 937,457
============= =============
The accompanying notes are an integral part of these consolidated
financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(1) BASIS OF PRESENTATION
Interim Financial Statements
The consolidated financial statements and accompanying financial information as
of June 30, 2002 and for the three and six months ended June 30, 2002 and 2001
are unaudited and, in the opinion of management, include all adjustments
(consisting only of normal recurring adjustments) which Predictive Systems, Inc.
(the "Company" or "Predictive") considers necessary for a fair presentation of
the financial position of the Company at such dates and the operating results
and cash flows for those periods. The financial statements included herein have
been prepared in accordance with generally accepted accounting principles and
the instructions of Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. These financial statements should be read in
conjunction with the Company's audited financial statements for the year ended
December 31, 2001 contained in its Annual Report on Form 10-K. Results for
interim periods are not necessarily indicative of results for the entire year.
Recently Issued Accounting Pronouncements
In July 2001, the FASB issued Statement of Financial Accounting Standards
No. 141, "Business Combinations" (SFAS 141) and No. 142, "Goodwill and Other
Intangible Assets" (SFAS 142). SFAS 141 requires all business combinations
initiated after June 30, 2001 to be accounted for using the purchase method of
accounting. Under SFAS 142, goodwill and intangible assets with indefinite lives
are no longer amortized but are reviewed annually (or more frequently if
impairment indicators arise) for impairment. Separable intangible assets that
are not deemed to have indefinite lives will continue to be amortized over their
useful lives (but with no maximum life). The amortization provisions of SFAS 142
apply to goodwill and intangible assets acquired after June 30, 2001. The
Company adopted the provisions of SFAS 142 effective January 1, 2002. As
required by the transitional provisions of SFAS 142, the Company evaluated
goodwill and intangible assets with indefinite lives for impairment as of
January 1, 2002. This evaluation was completed during the quarter ended June 30,
2002. As a result of this transitional testing, the Company recorded a noncash
impairment charge of $23,307,626 to reduce the carrying value of its goodwill
and other indefinite lived intangible assets. Such charge is reflected as a
cumulative effect of change in accounting principle in the accompanying
consolidated statements of operations for the six months ended June 30, 2002.
In July 2001, the FASB issued Statement of Financial Accounting Standard No.
143, "Accounting for Asset Retirement Obligations" (SFAS 143), which is
effective for fiscal years beginning after June 15, 2002. SFAS 143 requires,
among other things, the accounting and reporting of legal obligations associated
with the retirement of long-lived assets that result from the acquisition,
construction, development or normal operation of a long-lived asset. The Company
believes the adoption of SFAS 143 will not have a material impact on its
financial position or results of operations.
In August 2001, the FASB issued Statement of Financial Accounting Standard No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets" (SFAS
144). This statement supersedes Statement of Financial Accounting Standard No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" (SFAS 121) and Accounting Principles Board Opinion No.
30, "Reporting Results of Operations - Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions." The Statement retains the fundamental provisions of
SFAS 121 for recognition and measurement of impairment, but amends the
accounting and reporting standards for segments of a business to be disposed of.
The Company adopted the provisions of SFAS 144 effective January 1, 2002. Given
the decline in revenues and market capitalization of the Company and the overall
deterioration of market conditions in the enterprise sector, the Company
reviewed its long-lived assets for impairment as of June 30, 2002. Based on this
review, the Company recognized an impairment loss to reduce the carrying value
of its finite lived intangible assets and property and equipment of $8,743,545
and $4,510,193, respectively. Such charges are reflected in the accompanying
consolidated statements of operations for the three and six months ended June
30, 2002.
On November 14-15, 2001, the Emerging Issues Task Force (EITF) of the FASB
concluded that reimbursements received for "out-of-pocket" expenses should be
classified as revenue, and correspondingly cost of services, in the income
statement. This accounting treatment should be applied in financial reporting
periods (years) beginning as early as the March 2002 quarter. Upon application
of the pronouncement, comparative financial statements for prior periods must
also be reclassified in order to ensure consistency among all periods presented.
The Company adopted this pronouncement effective January 1, 2002 and has
separately disclosed the impact of adoption in the consolidated statements of
operations.
In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections."
This statement eliminates the automatic classification of gain or loss on an
extinguishment of debt as an extraordinary item of income and requires that such
gain or loss be evaluated for extraordinary classification under the criteria of
Accounting Principles Board No. 30 "Reporting Results of Operations." This
statement also requires sales-leaseback accounting for certain lease
modifications that have economic effects that are similar to sales-leaseback
transactions, and makes various other technical corrections to existing
pronouncements. This statement will be effective for the Company for the year
ending December 31, 2003. The Company is currently assessing, but has not yet
determined the effect, if any, of SFAS 145.
In July 2002, the Financial Accounting Standards Board issued SFAS No. 146,
"Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146
will supersede Emerging Issues Task Force Issue No. 94-3, "Liability Recognition
for Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." SFAS No. 146 requires
that costs associated with an exit or disposal plan be recognized when incurred
rather than at the date of a commitment to an exit or disposal plan. SFAS No.
146 is to be applied prospectively to exit or disposal activities initiated
after December 31, 2002. The Company is currently assessing, but has not yet
determined the effect, if any, of SFAS 146.
Reclassification
Certain prior year amounts have been reclassified to conform to their current
year presentation.
(2) NET INCOME (LOSS) PER SHARE
Basic net income (loss) per share is computed by dividing net income (loss)
available to common stockholders by the weighted average number of common shares
outstanding. Diluted net income (loss) per share reflects the potential dilution
that would occur if securities or other contracts to issue common stock were
exercised or converted into common stock, unless they are anti-dilutive.
The conversion of 9,632,729 and 11,023,988 outstanding options as of June 30,
2002 and 2001, respectively, were not considered in the calculation of diluted
net loss per share for any period presented as the effect would be
anti-dilutive.
(3) COMPREHENSIVE INCOME (LOSS)
The components of comprehensive income (loss) for the three and six months ended
June 30, 2002 and 2001 are as follows:
Three Months Ended Six Months Ended
June 30 June 30
---------------------------- ---------------------------
2002 2001 2002 2001
------------- ------------ ------------ ------------
(unaudited) (unaudited)
Net loss $(25,348,018) $(22,646,364) $(56,907,915) $(41,633,271)
Unrealized (loss) gain on
investments (815) (6,972) (2,158) 14,842
Foreign currency translation
adjustment (166,474) 97,028 226,180 (183,117)
------------- ------------ ------------ ------------
Comprehensive loss $(25,515,307) $(22,556,308) $(56,683,893) $(41,801,546)
============= ============ ============ ============
(4) GOODWILL AND INTANGIBLE ASSETS
In July 2001, the FASB issued SFAS No. 141, "Business Combinations" and SFAS No.
142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires that all
business combinations subsequent to June 30, 2001 be accounted for under the
purchase method of accounting. SFAS No. 141 also requires that the fair value of
an assembled workforce acquired be included in the amount initially recorded as
goodwill. The Company reclassified into goodwill $2,947,748 initially recorded
as other intangible assets related to the value of the assembled workforce of
Synet and Global Integrity as required by this statement. SFAS No. 142 requires
that upon adoption, amortization of goodwill and indefinite lived intangibles
cease, and instead, the carrying value of goodwill be evaluated for impairment
on at least an annual basis.
The Company has retroactively adopted this standard effective January 1, 2002.
The Company has evaluated goodwill and its tradename intangible for impairment
and has determined that an impairment of $23,307,626 existed at January 1, 2002.
Accordingly the Company has restated the results for the three months ended
March 31, 2002 to reflect the adoption of SFAS 142 as follows:
Three Months Ended
March 31, 2002
------------------
Originally reported net loss $ (8,252,271)
Cumulative effect of change in accounting
principle (23,307,626)
------------
Net loss as restated $(31,559,897)
============
Originally reported basic and diluted net loss per
common share $ (0.22)
Cumulative effect of change in accounting
principle (0.63)
------------
Basic and diluted net loss per
common share as restated $ (0.85)
============
The Company's reporting units utilized for evaluating the recoverability of
goodwill are the same as its operating segments.
The following table reports the amounts that loss and loss per basic and diluted
share before cumulative effect of change in accounting principle would have been
in all periods presented exclusive of goodwill and indefinite lived intangibles
amortization expense recognized in those periods.
Three Months Ended Six Months Ended
June 30, June 30,
--------------------------------- -----------------------------------
2002 2001 2002 2001
------------- ------------- ------------- --------------
Reported loss before cumulative
effect of change in accounting
principle $ (25,348,018) $ (22,646,364) $ (33,600,289) $(41,633,271)
Add: Goodwill amortization -- 4,931,026 -- 9,936,646
Add: Assembled workforce amortization -- 388,836 -- 777,810
Add: Tradenames amortization -- 126,500 -- 253,000
------------- ------------- ------------- --------------
Adjusted loss before cumulative effect
of change in accounting principle $ (25,348,018) $ (17,200,002) $ (33,600,289) $(30,665,815)
============= ============= ============= ==============
Reported basic and diluted loss per
common share before cumulative effect
of change in accounting principle $ (0.68) $ (0.63) $ (0.90) $ (1.17)
Add: Goodwill amortization -- 0.14 -- 0.28
Add: Assembled workforce amortization -- 0.01 -- 0.02
Add: Tradenames amortization -- -- -- 0.01
------------- ------------- ------------- --------------
Adjusted basic and diluted loss per
common share before cumulative effect $ (0.68) $ (0.48) $ (0.90) $ (0.86)
of change in accounting principle ============= ============= ============= ==============
Changes in the carrying amount of goodwill for the six months ended June 30,
2002, by operating segment, are as follows:
US Managed Security International
Consulting Services Consulting
------------- -------------- -------------
Balance as of January 1, 2002 $ 14,071,908 $ 7,485,804 $ 2,231,251
Cumulative effect of change in accounting principle (14,071,908) (7,485,804) --
------------- -------------- -------------
Balance as of June 30, 2002 $ -- $ -- $ 2,231,251
============= ============== =============
As of June 30, 2002 and December 31, 2001, the Company's intangible assets and
related accumulated amortization consisted of the following:
As of June 30, 2002 As of December 31, 2001
--------------------------------------- ---------------------------------------
Gross Gross
Carrying Accumulated Carrying Accumulated
Value Amortization Net Value Amortization Net
----------- ------------ ----------- ----------- ------------ -----------
Amortized intangible assets
Customer list $ -- $ -- $ -- $ 4,500,000 $ 1,629,168 $ 2,870,832
Developed technology -- -- -- 9,575,000 1,994,793 7,580,211
Assembled workforce -- -- -- 4,666,000 1,718,252 2,947,748
---------- ---------- ----------- ----------- ----------- -----------
Total -- -- -- 18,741,000 5,342,213 13,398,791
---------- ---------- ----------- ----------- ----------- -----------
Indefinite lived intangible assets
Tradenames -- -- -- 2,530,000 527,084 2,002,916
---------- ---------- ----------- ----------- ----------- -----------
Total -- -- -- 2,530,000 527,084 2,002,916
---------- ---------- ----------- ----------- ----------- -----------
Total $ -- $ -- $ -- $21,271,000 $ 5,869,297 $15,401,707
========== ========== =========== =========== =========== ===========
The aggregate amortization expense for other intangible assets was approximately
$980,250 and $1,369,086 during the three months ended June 30, 2002 and 2001,
respectively, and $1,960,500 and $2,738,245 during the six months ended June 30,
2002 and 2001, respectively. As of June 30, 2002, there are no intangible assets
remaining to be amortized.
(5) LONG-LIVED ASSETS IMPAIRMENT
As a result of the Company's operating performance for the six months ended June
30, 2002, the corresponding decline in its market capitalization, the general
economic environment, and its forecasted operating results for the foreseeable
future, the Company evaluated the carrying value of the long lived assets of its
US Consulting and Managed Security Services reporting units for impairment in
accordance with the provisions of SFAS 144. An impairment loss under SFAS 144 is
recognized if the carrying amount of a long-lived asset group is not recoverable
and exceeds its fair value. The carrying amount of a long-lived asset group is
not recoverable if it exceeds the sum of the undiscounted cash flows expected to
result from the use and eventual disposition of the asset group. An impairment
is measured as the amount by which the carrying amount of a long-lived asset
group exceeds its fair value. Given the projected operating performance over the
remaining useful lives of the definite lived intangible assets and other
long-lived assets for the US Consulting and Managed Security Services reporting
units, it was determined that the carrying value of these assets will not be
recoverable. As a result of these determinations, the Company recorded a charge
for the impairment of intangibles and the impairment of property and equipment
in its results of operations for the three and six months ended June 30, 2002 of
$8,743,545 and $4,510,193, respectively. The fair value of the asset groups was
determined based on the discounted cash flows to be generated from such asset
groups over the estimated remaining useful life of the principle asset in each
group.
The following is a summary of the impairment charges for the three and six
months ended June 30, 2002:
US Consulting Managed Security Services Total
------------- ------------------------- ------------
Impairment of
intangibles:
Customer lists $ 1,254,585 $ 866,249 $ 2,120,834
Developed technology 2,185,495 4,437,216 6,622,711
------------ ------------ ------------
$ 3,440,080 $ 5,303,465 $ 8,743,545
============ ============ ============
Impairment of property and equipment:
Computer equipment $ 1,587,881 $ 285,779 $ 1,873,660
Office furniture 268,624 - 268,624
Capitalized software 2,217,879 - 2,217,879
Leasehold improvements 150,030 - 150,030
------------ ------------ ------------
$ 4,224,414 $ 285,779 $ 4,510,193
============ ============ ============
(6) RELATED PARTIES
The Company provides network consulting services to Cisco Systems, Inc.
("Cisco") pursuant to an existing agreement. This agreement provides that if the
Company gives more favorable rates to another client it will inform Cisco and
Cisco will have the right to terminate this agreement. One of the Company's
directors is also an officer of Cisco. Additionally, in September 1999, the
Company sold 1,242,000 shares of common stock to Cisco for $12.00 per share. For
the six months ended June 30, 2002 and 2001, the Company recognized revenues of
approximately $28,000 and $604,000, respectively, from services performed for
Cisco Systems. As of June 30, 2002, amounts due from Cisco were $447. Such
amount is included in related party receivables. There were no amounts due from
Cisco as of December 31, 2001.
The Company provides network consulting services to BellSouth Corporation
("BellSouth") pursuant to an existing agreement. One of the Company's directors
is also an officer of BellSouth. For the six months ended June 30, 2002 and
2001, the Company recognized revenues of $4.4 million and $7.5 million,
respectively, from services performed for BellSouth. As of June 30, 2002 and
December 31, 2001, amounts due from BellSouth were $1,191,282 and $994,322,
respectively. Such amounts are included in related party receivables.
The Company provides network consulting services to Riversoft PLC pursuant to an
agreement. Additionally, the Company purchased approximately $500,000 of
software inventory from Riversoft in 2001. Two of the Company's directors served
on Riversoft PLC's Board of Directors, one of which served until December 19,
2001. One of the directors is also a general partner for a venture capital firm,
which owns approximately 10% of Riversoft PLC. For the six months ended June 30,
2001, the Company recognized revenues of $69,950 from services performed for
Riversoft PLC. No revenues were recognized for the six months ended June 30,
2002. As of June 30, 2002 and December 31, 2001, amounts due from Riversoft PLC
were $7,000 and $50,343, respectively. Such amounts are included in related
party receivables.
The Company and Science Application International Corporation ("SAIC") provide
network and security consulting services to each other pursuant to existing
agreements. For the six months ended June 30, 2002 and 2001, revenues from SAIC
were approximately $132,000 and $128,000, respectively, and the Company
purchased approximately $4,000 and $76,000, respectively, in consulting services
from SAIC. Additionally, SAIC provides the Company with various services
relating to alarm, telecommunications and IT support functions and the Company
rents certain of its office space from SAIC. For the six months ended June 30,
2002 and 2001, the Company purchased approximately $542,000 and $520,000,
respectively, for such services and the rental of office space. Of the purchases
for the six months ended June 30, 2002, approximately $136,000 were expensed in
the six months ended June 30, 2002. The remaining purchases were accrued in the
prior year in connection with our acquisition plan. In addition, the Company and
SAIC license certain of their respective intellectual property to the other. The
Company believes that these transactions are on terms that are no less favorable
than those that could be obtained from unaffiliated third parties. As of June
30, 2002, $144,947 was due from SAIC. Such amount is included in related party
receivables. There were no amounts due from SAIC as of December 31, 2001.
On December 22, 2000, the Company purchased a $1,000,000 12% Convertible
Promissory Note (the "Note") of Paradigm4, Inc. ("Paradigm4") which the Company
recorded as a long-term investment in related party. The Note was payable 90
days from the date of purchase. The Company received a stock purchase warrant
(the "Warrant") to purchase up to 0.7692% of the outstanding shares of Paradigm4
on a fully diluted basis at a price equal to $.01 per share. The Warrant was
exercisable immediately and expires on December 22, 2005. On March 22, 2001,
Paradigm4 filed for federal bankruptcy protection. This action created
significant uncertainty regarding the Company's investment in Paradigm4. As a
result, the Company recorded a loss of $1.0 million on its investment for the
six months ended June 30, 2001.
Receivables from employees and stockholders represent short term lending to such
parties entered into in the normal course of business.
(7) RESTRUCTURING AND OTHER CHARGES
In February 2001, the Company's management foresaw the need to lower the
operating costs of the business given its near-term revenue projections.
Therefore, the Company established a plan that included the following: (1) a
reduction in its workforce for both domestic and international operations
related to professional consultant employees that had been underutilized for
several months and also to employees that held various management, sales and
administrative positions deemed to be duplicative functions; (2) the closing of
several domestic and international regional offices located in geographic areas
that no longer cost justified remaining open; and (3) the discontinuance of
electronic equipment leases and other expenses related to the reduction in
workforce.
In December 2001, the Company formed a strategic alliance with Riptech, Inc.
("Riptech"), an unaffiliated third party, to outsource its monitoring services
provided by the Managed Security Services division. As a result of this
alliance, the Company established a restructuring plan that included the
following: (1) a reduction of the Company's workforce; (2) the write-off of
equipment and software development costs associated with the Company's security
operations center which was no longer needed as a result of the outsourcing; and
(3) the incurrence of nonrecoverable costs to convert clients to Riptech.
In January 2002, the Company's management foresaw the need to continue to lower
the operating costs of the business given continuing difficult market conditions
in the enterprise sector. Therefore, the Company established a 2002
restructuring plan that included the following: (1) a reduction in its workforce
for both domestic and international operations related to professional
consultant employees that had been underutilized for several months and also to
employees that held various management, sales and administrative positions
deemed to be duplicative functions; (2) the closing of additional domestic
regional offices located in geographic areas that no longer cost justified
remaining open; and (3) the discontinuance of electronic equipment leases and
other expenses related to the reduction in force.
For the three months ended June 30, 2002, the Company recorded restructuring
charges of $3,303,102 in connection with its 2002 restructuring plan. Such
charges consisted of $1,272,630 in severance benefits and other related expenses
for a reduction in headcount of 59 employees and $2,030,472 in exit costs
related to real estate and electronic equipment for the closing of domestic
offices. For the three months ended June 30, 2001, the Company recorded
restructuring charges of $2,634,085 in connection with its 2001 restructuring
plan. Such charges consisted of $1,175,471 in severance benefits and other
related expenses for a reduction in headcount of 68 employees and $1,458,614 in
exit costs related to real estate and electronic equipment. These charges have
been reflected as operating expenses of the Company.
For the six months ended June 30, 2002, the Company recorded restructuring
charges of $4,236,604 in connection with its 2002 restructuring plan. Such
charges consisted of $2,091,347 in severance benefits and other related expenses
for a reduction in headcount of 106 employees and $2,295,257 in exit costs
related to real estate and electronic equipment for the closing of domestic
offices. These charges were offset by $150,000 received for equipment
written-off to restructuring charges in 2001 in connection with the outsourcing
of the Company's monitoring services provided as part of the Managed Security
Services division. For the six months ended June 30, 2001, the Company recorded
restructuring charges of $3,275,033 in connection with its 2001 restructuring
plan. Such charges consisted of $1,816,419 in severance benefits and other
related expenses for a reduction in headcount of 138 employees and $1,458,614 in
exit costs related to real estate and electronic equipment. These charges have
been reflected as operating expenses of the Company. As of June 30, 2002,
restructuring charges of $3,170,713 remained unpaid and are included in accrued
expenses and other current liabilities on the accompanying consolidated balance
sheet.
A summary of the restructuring charges for the six months ended June 30, 2002
were as follows:
Balance as Utilization Balance as
of 12/31/01 Expense Non-Cash Cash of 6/30/02
--------------- -------------- ---------------- ------------------ --------------
Severance $ 17,320 $ 2,091,347 $ - $ 1,193,495 $ 915,172
Exit Costs 1,115,996 2,295,257 497,319 939,316 1,974,618
Outsourcing monitoring services 722,224 (150,000) - 291,301 280,923
-------------- --------------- ---------------- ------------------ --------------
$ 1,855,540 $ 4,236,604 $ 497,319 $ 2,424,112 $ 3,170,713
============== =============== ================ ================== ==============
In June 2001, the Company wrote off $1,029,732 related to the abandonment of
internal software management tools that no longer suited the business needs of
the Company.
(8) INDUSTRY SEGMENT INFORMATION
The Company's reportable segments are US Consulting, International Consulting,
and Managed Security Services. Revenues and profits in the US Consulting and
International Consulting segments are generated by providing the following
services: network design and engineering, network and systems management,
integrated customer service, performance management, information security, and
business integration services.
Revenues and profits in the Managed Security Services segment are generated by
providing the following services: response and threat advisory through
Information Sharing and Analysis Centers, remote monitoring and management of
firewalls and providing of Open Source Intelligence programs.
The accounting policies of the segments are the same as those described in the
"Summary of Significant Accounting Policies," included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2001. The Company evaluates
the performance of its segments based on their operating income (loss), which
represents segment revenues less direct costs of operation, excluding the
allocation of corporate expenses. Identifiable assets of the operating segments
principally consist of net accounts receivable, unbilled work in process and
inventory held for resale. Accounts receivable and unbilled work in process for
US Consulting and Managed Security Services are managed on a combined basis. All
other identifiable assets not attributable to industry segments are included in
corporate assets. The Company does not track expenditures for long-lived assets
on a segment basis. The table below presents information on the revenues and
operating loss for each segment for the three and six months ended June 30, 2002
and 2001, and items which reconcile segment operating loss to the Company's
reported loss before cumulative effect of change in accounting principle.
Three Months Ended June 30 Six Months Ended June 30
2002 2001 2002 2001
------------------------------- --------------------------------
Revenues:
US Consulting ..................................... $ 8,966,363 $ 15,626,300 $ 19,831,497 $ 33,136,807
International Consulting .......................... 2,289,984 1,700,172 4,504,218 3,494,725
Managed Security Services ......................... 701,540 1,556,906 2,652,739 3,591,276
------------- ------------- ------------- -------------
Total revenues .................................... 11,957,887 18,883,378 26,988,454 40,222,808
------------- ------------- ------------- -------------
Operating loss:
US Consulting ..................................... (7,970,442) (1,815,829) (8,081,633) (5,070,391)
International Consulting .......................... (181,333) (2,152,908) (244,179) (3,310,985)
Managed Security Services ......................... (6,124,008) (741,700) (6,133,285) (1,543,036)
------------- ------------- ------------- -------------
Total operating loss .............................. (14,275,783) (4,710,437) (14,459,097) (9,924,412)
------------- ------------- ------------- -------------
Corporate expenses:
Sales and marketing ............................... (221,506) (521,881) (543,476) (1,181,247)
General and administrative ........................ (4,810,333) (6,981,854) (9,523,227) (12,287,840)
Depreciation and amortization ..................... (732,383) (953,284) (1,506,785) (1,719,779)
Intangibles amortization .......................... (980,250) (6,300,112) (1,960,500) (12,674,891)
Restructuring and other charges ................... (3,303,102) (3,663,817) (4,236,604) (4,304,765)
Loss on long-term investment in related party ..... - - - (1,000,000)
Noncash compensation expense ...................... (37,554) (107,969) (73,173) (218,236)
Interest income, net .............................. 107,389 668,659 242,637 1,731,683
Other expense, net ................................ (1,094,496) (75,669) (1,540,064) (53,784)
------------- ------------- ------------- -------------
Total corporate expenses .......................... (11,072,235) (17,935,927) (19,141,192) (31,708,859)
------------- ------------- ------------- -------------
Loss before cumulative effect of change in accounting
principle ............................................... $ (25,348,018) $ (22,646,364) $ (33,600,289) $ (41,633,271)
============= ============= ============= =============
Identifiable assets:
US Consulting and Managed Security Services ....... $ 9,876,911 $ 25,830,306 $ 9,876,911 $ 25,830,306
International Consulting .......................... 1,740,122 1,757,072 1,740,122 1,757,072
Corporate ......................................... 30,291,067 183,297,634 30,291,067 183,297,634
------------- ------------- ------------- -------------
Total identifiable assets ......................... $ 41,908,100 210,885,012 $ 41,908,100 $ 210,885,012
============= ============= ============= =============
(9) CONTINGENCIES
Except as set forth below, the Company is not a party to any material legal
proceedings.
On November 13, 2001, a securities class action complaint was filed in the
United States District Court for the Southern District of New York against
Predictive, four investment banks that underwrote the Company's initial public
offering, and three of the Company's former officers and directors. This action
has been coordinated with over three hundred virtually identical actions against
other companies and the investment banks that underwrote their initial public
offerings. The complaint filed against the Company generally alleged that the
underwriters obtained excessive and undisclosed commissions from customers who
received allocations of shares in the Company's initial and secondary public
offerings and that the underwriters maintained artificially inflated prices in
the after market through "tie-in" arrangements, which required customers to buy
additional shares of the Company's stock at pre-determined prices in excess of
the offering prices. The complaint further alleged that the Company and certain
of its officers and directors violated Sections 11, 12(a)(2) and 15 of the
Securities Act of 1933 because the Company's registration statement did not
disclose the underwriters' purported misconduct. On April 20, 2002, the
plaintiffs amended their complaint, abandoning the Section 12(a)(2) claim, but
alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act,
and of Rule 10b-5 promulgated thereunder. Plaintiffs seek an unspecified amount
of damages on behalf of persons who purchased the Company's stock pursuant to
the registration statements. The Company believes that the allegations against
it are without merit and intends to defend the case vigorously.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS RELATING TO FUTURE EVENTS AND
FUTURE PERFORMANCE OF THE COMPANY WITHIN THE MEANING OF SECTION 27A OF THE
SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934,
INCLUDING, WITHOUT LIMITATION, STATEMENTS REGARDING THE COMPANY'S EXPECTATIONS,
BELIEFS, INTENTIONS OR FUTURE STRATEGIES THAT ARE SIGNIFIED BY THE WORDS
EXPECTS, ANTICIPATES, INTENDS, BELIEVES OR SIMILAR LANGUAGE. ACTUAL RESULTS
COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN SUCH FORWARD-LOOKING
STATEMENTS. ALL FORWARD-LOOKING STATEMENTS INCLUDED IN THIS DOCUMENT ARE BASED
ON INFORMATION AVAILABLE TO THE COMPANY ON THE DATE HEREOF, AND THE COMPANY
ASSUMES NO OBLIGATION TO UPDATE ANY FORWARD LOOKING STATEMENTS. THE COMPANY
CAUTIONS INVESTORS THAT ITS BUSINESS AND FINANCIAL PERFORMANCE ARE SUBJECT TO
SUBSTANTIAL RISKS AND UNCERTAINTIES. IN EVALUATING THE COMPANY'S BUSINESS,
PROSPECTIVE INVESTORS SHOULD CAREFULLY CONSIDER THE INFORMATION SET FORTH BELOW
UNDER THE CAPTION "RISK FACTORS" IN ADDITION TO THE OTHER INFORMATION SET FORTH
HEREIN AND ELSEWHERE IN THE COMPANY'S OTHER PUBLIC FILINGS WITH THE SECURITIES
AND EXCHANGE COMMISSION.
Substantially all of our revenues are derived from professional services. We
provide network and security consulting services to our clients on either a
project outsource or collaborative consulting basis. We derive revenues from
these services on both a fixed-price, fixed-time basis and on a time-and-expense
basis. We also provide managed security services to our clients. We derive
revenues from these services on a subscription basis. We use our BusinessFirst
approach to estimate and propose prices for our fixed-price projects. The
estimation process accounts for standard billing rates particular to each
project, the client's technology environment, the scope of the project and the
project's timetable and overall technical complexity. A member of our senior
management team must approve all of our fixed-price proposals in excess of
$500,000. For these contracts, we recognize revenue using a
percentage-of-completion method primarily based on costs incurred. We make
provisions for estimated losses on uncompleted contracts on a
contract-by-contract basis and recognize such provisions in the period in which
the losses are determined. Professional services revenues for time-and-expense
based projects are recognized as services are performed. Revenues for
subscription-based contracts are recognized on a straight-line basis over the
period of service. Any payments received in advance of services performed are
recorded as deferred revenue. Our clients are generally able to reduce or cancel
their use of our professional services without penalty and with little or no
notice. We also derive limited revenues from the sale of hardware and software.
Since we recognize professional services revenues only when our consultants are
engaged on client projects, the utilization of our consultants is important in
determining our operating results. In addition, a substantial majority of our
operating expenses, particularly personnel and related costs, depreciation and
rent, are relatively fixed in advance of any particular quarter. As a result,
any underutilization of our consultants may cause significant variations in our
operating results in any particular quarter and could result in losses for such
quarter. Factors which could cause underutilization include:
- the reduction in size, delay in commencement, interruption or termination of
one or more significant projects;
- the completion during a quarter of one or more significant projects;
- the miscalculation of resources required to complete new or ongoing projects;
and
- the timing and extent of training, weather related shut-downs, vacations and
holidays.
Our cost of revenues consist of costs associated with our professional services
and hardware and software purchases. Costs of revenues associated with
professional services include compensation and benefits for our consultants and
project-related travel expenses. Costs of hardware and software purchases
consist of acquisition costs of third-party hardware and software resold.
Given the decline in revenue related to the service provider customer base,
coupled with the continuing uncertainty in the professional network consulting
services marketplace, we believe that our quarterly revenue and operating
results are likely to vary significantly in the future and that period-to-period
comparisons of our operating results are not necessarily meaningful and should
not be relied on as indications of future performance.
In February 2001, the Company's management foresaw the need to lower the
operating costs of the business given its near-term revenue projections.
Therefore, the Company established a plan that included the following: (1) a
reduction in its workforce for both domestic and international operations
related to professional consultant employees that had been underutilized for
several months and also to employees that held various management, sales and
administrative positions deemed to be duplicative functions; (2) the closing of
several domestic and international regional offices located in geographic areas
that no longer cost justified remaining open; and (3) the discontinuance of
electronic equipment leases and other expenses related to the reduction in
workforce.
In December 2001, the Company formed a strategic alliance with Riptech, Inc., an
unaffiliated third party, to outsource its monitoring services provided by the
Managed Security Services division. As a result of this alliance, the Company
established a restructuring plan that included the following: (1) a reduction of
the Company's workforce; (2) the write-off of equipment and software development
costs associated with the Company's security operations center which was no
longer needed as a result of the outsourcing; and (3) the incurrence of
nonrecoverable costs to convert clients to Riptech.
In January 2002, the Company's management foresaw the need to continue to lower
the operating costs of the business given continuing difficult market conditions
in the enterprise sector. Therefore, the Company established a 2002
restructuring plan that included the following: (1) a reduction in its workforce
for both domestic and international operations related to professional
consultant employees that had been underutilized for several months and also to
employees that held various management, sales and administrative positions
deemed to be duplicative functions; (2) the closing of additional domestic
regional offices located in geographic areas that no longer cost justified
remaining open; and (3) the discontinuance of electronic equipment leases and
other expenses related to the reduction in workforce.
For the three months ended June 30, 2002, the Company recorded restructuring
charges of $3,303,102 in connection with its 2002 restructuring plan. Such
charges consisted of $1,272,630 in severance benefits and other related expenses
for a reduction in headcount of 59 employees and $2,030,472 in exit costs
related to real estate and electronic equipment for the closing of domestic
offices. For the three months ended June 30, 2001, the Company recorded
restructuring charges of $2,634,085 in connection with its 2001 restructuring
plan. Such charges consisted of $1,175,471 in severance benefits and other
related expenses for a reduction in headcount of 68 employees and $1,458,614 in
exit costs related to real estate and electronic equipment. These charges have
been reflected as operating expenses of the Company.
For the six months ended June 30, 2002, the Company recorded restructuring
charges of $4,236,604 in connection with its 2002 restructuring plan. Such
charges consisted of $2,091,347 in severance benefits and other related expenses
for a reduction in headcount of 106 employees and $2,295,257 in exit costs
related to real estate and electronic equipment for the closing of domestic
offices. These charges were offset by $150,000 received for equipment
written-off to restructuring charges in 2001 in connection with the outsourcing
of the Company's monitoring services provided as part of the Managed Security
Services division. For the six months ended June 30, 2001, the Company recorded
restructuring charges of $3,275,033 in connection with its 2001 restructuring
plan. Such charges consisted of $1,816,419 in severance benefits and other
related expenses for a reduction in headcount of 138 employees and $1,458,614 in
exit costs related to real estate and electronic equipment. These charges have
been reflected as operating expenses of the Company.
Critical Accounting Policies and Estimates
This discussion and analysis of our financial condition and results of
operations are based on our consolidated financial statements that have been
prepared under generally accepted accounting principles. The preparation of
financial statements in conformity with generally accepted accounting principles
requires our management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and the disclosure of contingent
assets and liabilities at the date of the financial statements and the reported
amounts of revenue and expenses during the reporting period. Actual results
could materially differ from those estimates. We have disclosed all significant
accounting policies in note 2 to the consolidated financial statements included
in the Company's Annual Report on Form 10-K for the year ended December 31,
2001. The consolidated financial statements and the related notes thereto should
be read in conjunction with the following discussion of our critical accounting
policies. Our critical accounting policies and estimates are:
o Revenue recognition
o Valuation of goodwill, intangible assets and other long-lived
assets
o Stock based compensation
o Income taxes
Revenue Recognition: We currently recognize revenue from professional services.
As described below, significant management judgments and estimates must be made
and used in determining the amount of revenue recognized in any given accounting
period. Material differences may result in the amount and timing of our revenue
for any given accounting period depending upon judgments made by or estimates
utilized by management.
We recognize revenue for fixed price contracts in accordance with SOP 81-1,
"Accounting for Performance of Construction Type and Certain Production Type
Contracts" (SOP 81-1). When reliable estimates are available for the costs and
efforts necessary to complete the consulting services and those services do not
include contractual milestones or other acceptance criteria, we recognize
revenue under the percentage of completion method based upon input measures,
such as hours. When such estimates are not available, we defer all revenue
recognition until we have completed the contract and have no further obligations
to the customer. Under each arrangement, revenues are recognized when a
non-cancelable agreement has been signed and the customer acknowledges an
unconditional obligation to pay, the services have been delivered, there are no
uncertainties surrounding customer acceptance, the fees are fixed and
determinable, and collection is considered probable.
Goodwill and Indefinite Lived Intangibles: Goodwill consists of the excess
purchase price over the fair value of identifiable net assets of acquired
businesses. Indefinite lived intangibles consist of the Company's tradename
intangible. The carrying value of goodwill and indefinite lived intangibles are
evaluated for impairment on an annual basis. Management also reviews goodwill
and its indefinite lived intangibles for impairment whenever events or changes
in circumstances indicate that their carrying amount may be impaired. If it is
determined that an impairment in value has occurred, goodwill and indefinite
lived intangibles will be written down to the present value of the expected
future operating cash flows to be generated by the respective reporting unit.
The Company has evaluated goodwill and its tradename intangible for impairment
and has determined that impairment of $23,307,626 exists at January 1, 2002. The
Company's reporting units utilized for evaluating the recoverability of goodwill
and the indefinite lived intangibles are the same as its operating segments.
Other Intangible Assets: Other intangible assets are carried at cost less
accumulated amortization and are amortized on a straight-line basis over their
expected lives, which are estimated to be three to five years. Other intangible
assets of the Company are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of the asset may not be
recoverable. Management also reevaluates the periods of amortization of other
intangible assets to determine whether events and circumstances warrant revised
estimates of useful lives. The Company evaluates the carrying value of its
long-lived assets in relation to the operating performance and future
undiscounted cash flows of the asset when indications of impairment are present.
If it is determined that an impairment in value has occurred, the excess of the
value of the asset will be written down to the present value of the expected
future operating cash flows to be generated by the asset. At June 30, 2002 the
Company determined that its customer list and developed technology intangibles
were impaired and recorded an impairment charge of $8,743,545.
Impairment of long-lived assets: Long-lived assets of the Company are reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount of the asset may not be recoverable. Management also reevaluates
the periods of amortization of long-lived assets to determine whether events and
circumstances warrant revised estimates of useful lives. The Company evaluates
the carrying value of its long-lived assets in relation to the operating
performance and future undiscounted cash flows of the asset when indications of
impairment are present. If it is determined that an impairment in value has
occurred, the excess of the value of the asset will be written down to the
present value of the expected future operating cash flows to be generated by the
asset. Based on the continuing difficult market conditions in the enterprise
sector and the Company's decline in revenue from current periods, the Company
determined that indications of impairment were present and reviewed its
long-lived assets for impairment as of June 30, 2002. The Company determined
that property and equipment of its US Consulting and Managed Security Services
segments were impaired and recorded a $4,510,193 asset impairment charge.
Stock-based compensation: The Company accounts for its stock-based compensation
arrangements with its employees in accordance with the provisions of Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and
complies with the disclosure provisions of SFAS 123, "Accounting for Stock-based
Compensation." SFAS 123 established a fair-value-based method of accounting for
stock-based compensation plans.
Income Taxes: We have a history of unprofitable operations from the operating
losses incurred, which generated significant state and federal tax net operating
losses, or NOL carryforward. Generally accepted accounting principles in the
United States require that we record a valuation allowance against the deferred
tax asset associated with this NOL if it is "more likely than not" that we will
not be able to utilize it to offset future taxes. Due to our history of
unprofitable operations, we have recorded a valuation allowance equal to 100% of
these deferred tax assets. It is possible, however, that we could be profitable
in the future at levels which cause management to conclude that it is more
likely than not that we will realize all or a portion of the NOL carryforward.
Upon reaching such a conclusion, we would record the estimated net realizable
value of the deferred tax asset at that time and would then provide for income
taxes at a rate equal to our combined federal and state effective rates.
Subsequent revisions to the estimated net realizable value of the deferred tax
asset could cause our provision for income taxes to vary significantly from
period to period, although our cash tax payments would remain unaffected until
the benefit of the NOL is utilized.
RESULTS OF OPERATIONS
Three Months Ended June 30, 2002 and 2001
REVENUES. Substantially all of our revenues are derived from fees for
professional services. Revenues decreased 36.7% to $12.0 million in the three
months ended June 30, 2002 from $18.9 million in the three months ended June 30,
2001. Revenues from professional services decreased 35.2% to $11.6 million in
the three months ended June 30, 2002 from $17.8 million in the three months
ended June 30, 2001. This decrease was primarily due to difficult market
conditions in the enterprise sector. Reimbursed expenses decreased to $323,000
in the three months ended June 30, 2002 from $550,000 in the three months ended
June 30, 2001. This decrease was primarily attributable to the nature of the
customer contracts. Revenues from hardware and software sales decreased 83.9% to
$79,000 in the three months ended June 30, 2002 from $492,000 in the three
months ended June 30, 2001. This decrease was primarily due to a decrease in
client requests for hardware and software in connection with professional
services projects. During the three months ended June 30, 2002 and 2001,
BellSouth Corporation accounted for 18.1% and 20.2%, respectively, of our
revenues, excluding reimbursed expenses. The number of our billable consultants
decreased from approximately 429 at June 30, 2001 to approximately 254 at June
30, 2002.
GROSS PROFIT. Gross profit decreased 40.0% to $2.7 million in the three months
ended June 30, 2002 from $4.5 million in the three months ended June 30, 2001.
As a percentage of revenues, gross profit decreased to 22.4% in the three months
ended June 30, 2002 from 23.6% in the three months ended June 30, 2001. Included
in gross profit for the three months ended June 30, 2001 is $500,000 for the
write-off of software inventory which was no longer deemed to be saleable.
Excluding the impact of this write-off, gross margin was 26.3% for the three
months ended June 30, 2001. The decrease in gross profit as a percentage of
revenues, excluding the impact of the software inventory write-off, is a result
of declining revenues in a difficult market environment. Cost of revenues
decreased 35.6% to $9.3 million in the three months ended June 30, 2002 from
$14.4 million in the three months ended June 30, 2001. This decrease in cost of
revenues was due primarily to a decrease in compensation and benefits paid to
consultants as a result of reductions in billable headcount in connection with
our restructuring plans and the $500,000 write-off of software inventory in
2001.
SALES AND MARKETING EXPENSES. Sales and marketing expenses decreased 52.8% to
$2.2 million in the three months ended June 30, 2002 from $4.7 million in the
three months ended June 30, 2001. As a percentage of revenues, sales and
marketing expenses decreased to 18.7% in the three months ended June 30, 2002
from 25.0% in the three months ended June 30, 2001. The decrease in absolute
dollars was primarily due to an decrease of $2.0 million in compensation and
benefits paid due to reductions in headcount in connection with our
restructuring plans and a decrease of $256,000 in commissions paid as a result
of declining revenues for professional services and the merging of two separate
sales forces for US Consulting and Managed Security Services in 2002. The
remaining $279,000 decrease in sales and marketing expenses was a result of
decreased spending for marketing and selling efforts as part of our cost cutting
measures taken in 2002 and a decline in travel costs.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased 45.6% to $6.5 million in the three months ended June 30, 2002 from
$12.0 million in the three months ended June 30, 2001. As a percentage of
revenues, general and administrative expenses decreased to 54.3% in the three
months ended June 30, 2002 from 63.3% in the three months ended June 30, 2001.
The decrease in absolute dollars was primarily due to a decrease of $2.3 million
in compensation and benefits costs as a result of reductions in headcount in
connection with our restructuring plans, a decrease of $1.3 million in travel
and entertainment and training costs also as a result of reductions in
headcount, a decrease of $1.1 million in bad debt expense, a decrease of
$624,000 in facilities and equipment leases, and a decrease of $157,000 in
professional services and other administrative costs.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased 23.2% to
$732,000 in the three months ended June 30, 2002 from $953,000 in the three
months ended June 30, 2001. The decrease was primarily attributable to the
write-off of property and equipment in connection with our restructuring plans.
INTANGIBLES AMORTIZATION. Amortization of intangibles decreased to $980,000 for
the three months ended June 30, 2002 from $6.3 million for the three months
ended June 30, 2001. For the three months ended June 30, 2002, the amount
consisted of amortization for intangible assets deemed to have finite lives
pursuant to the provisions of SFAS 142 which was adopted effective January 1,
2002. Such intangible assets consisted of customer lists and developed
technology. Intangibles amortization for the three months ended June 30, 2001
consisted of amortization for all intangible assets, including goodwill,
assembled workforce and tradenames.
IMPAIRMENT OF INTANGIBLES. We adopted the provisions of SFAS 144 effective
January 1, 2002. Given the decline in revenues and our market capitalization,
the overall deterioration of market conditions in the enterprise sector, and
our forecasted operating results for the foreseeable future, we reviewed our
long-lived assets for impairment as of June 30, 2002. Based on this review, we
recognized an impairment loss of $8.7 million to reduce the carrying value of
our finite lived intangible assets, consisting of customer lists and developed
technology.
IMPAIRMENT OF PROPERTY AND EQUIPMENT. We adopted the provisions of SFAS 144
effective January 1, 2002. Given the decline in revenues and our market
capitalization, the overall deterioration of market conditions in the enterprise
sector, and our forecasted operating results for the foreseeable future we
reviewed our long-lived assets for impairment as of June 30, 2002. Based on this
review, we recognized an impairment loss of $4.5 million to reduce the carrying
value of our property and equipment, consisting of computer equipment, furniture
and fixtures, capitalized software and leasehold improvements.
RESTRUCTURING AND OTHER CHARGES. For the three months ended June 30, 2002, we
recorded restructuring charges of $3.3 million in connection with our 2002
restructuring plan. Such charges consisted of $1.3 million in severance benefits
and other related expenses for a reduction in headcount of 59 employees and $2.0
million in exit costs related to real estate and electronic equipment for the
closing of domestic offices. For the three months ended June 30, 2001, we
recorded restructuring charges of $2.6 million in connection with our 2001
restructuring plan. Such charges consisted of $1.2 million in severance benefits
and other related expenses for a reduction in headcount of 68 employees and $1.4
million in exit costs related to real estate and electronic equipment.
Additionally included in the financial statement caption for the three months
ended June 30, 2001 is $1.0 million related to the write-off of internal
software management tools that no longer suit our business needs.
NONCASH COMPENSATION EXPENSE. During 1999, we granted options to purchase shares
of common stock at exercises prices that were less than the fair market value of
the underlying shares of common stock, resulting in deferred compensation.
During 2000, in connection with our acquisitions of Synet and Global Integrity,
we issued options to Synet and Global Integrity optionholders in exchange for
their Synet and Global Integrity options, respectively. The unvested portion of
the Synet and Global Integrity options resulted in deferred compensation. These
transactions result in noncash compensation expense over the period that these
specific options vest. During the three months ended June 30, 2002 and 2001, we
recorded approximately $38,000 and $108,000, respectively, of noncash
compensation expenses related to these options. The decrease in noncash
compensation expense is a result of the cancellation of options as a result of
reductions in headcount in connection with our restructuring plans.
OTHER INCOME (EXPENSE). Other expense for the three months ended June 30, 2002
primarily consisted of the write-off of approximately $1.5 million of inventory
held for resale which was no longer deemed saleable. As the Company is acting as
an agent of the supplier in the arrangement for the resale of this inventory and
the revenues are recognized on a net basis, such write-off has been classified
as other expense. Other income for the three months ended June 30, 2001
primarily consisted of interest income.
Six Months Ended June 30, 2002 and 2001
REVENUES. Substantially all of our revenues are derived from fees for
professional services. Revenues decreased 32.9% to $27.0 million in the six
months ended June 30, 2002 from $40.2 million in the six months ended June 30,
2001. Revenues from professional services decreased 32.8% to $25.7 million in
the six months ended June 30, 2002 from $38.2 million in the six months ended
June 30, 2001. This decrease was primarily due to difficult market conditions in
the enterprise sector. Reimbursed expenses decreased to $724,000 in the six
months ended June 30, 2002 from $1.1 million in the six months ended June 30,
2001. This decrease was primarily attributable to the nature of the customer
contracts. Revenues from hardware and software sales decreased 32.5% to $603,000
in the six months ended June 30, 2002 from $893,000 in the six months ended June
30, 2001. This decrease was primarily due to a decrease in client requests for
hardware and software in connection with professional services projects. During
the six months ended June 30, 2002 and 2001, BellSouth Corporation accounted for
16.7% and 19.1%, respectively, of our revenues, excluding reimbursed expenses.
The number of our billable consultants decreased from approximately 429 at June
30, 2001 to approximately 254 at June 30, 2002.
GROSS PROFIT. Gross profit decreased 30.9% to $6.6 million in the six months
ended June 30, 2002 from $9.6 million in the six months ended June 30, 2001. As
a percentage of revenues, gross profit decreased to 24.6% in the six months
ended June 30, 2002 from 23.9% in the six months ended June 30, 2001. Included
in gross profit for the six months ended June 30, 2001 is $500,000 for the
write-off of software inventory which was no longer deemed to be saleable.
Excluding the impact of this write-off, gross margin was 25.1% for the six
months ended June 30, 2001. The decrease in gross profit as a percentage of
revenues, excluding the impact of the software inventory write-off, is a result
of declining revenues in a difficult market environment. Cost of revenues
decreased 33.5% to $20.3 million in the six months ended June 30, 2002 from
$30.6 million in the six months ended June 30, 2001. This decrease in cost of
revenues was due primarily to a decrease in compensation and benefits paid to
consultants as a result of reductions in billable headcount in connection with
our restructuring plans and the $500,000 write-off of software inventory in
2001.
SALES AND MARKETING EXPENSES. Sales and marketing expenses decreased 46.4% to
$5.0 million in the six months ended June 30, 2002 from $9.3 million in the six
months ended June 30, 2001. As a percentage of revenues, sales and marketing
expenses decreased to 18.4% in the six months ended June 30, 2002 from 23.1% in
the six months ended June 30, 2001. The decrease in absolute dollars was
primarily due to an decrease of $3.3 million in compensation and benefits paid
due to reductions in headcount in connection with our restructuring plans and a
decrease of $563,000 in commissions paid as a result of declining revenues for
professional services and the merging of two separate sales forces for US
Consulting and Managed Security Services in 2002. The remaining $502,000
decrease in sales and marketing expenses was a result of decreased spending for
marketing and selling efforts as part of our cost cutting measures taken in 2002
and a decline in travel costs.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased 45.4% to $12.9 million in the six months ended June 30, 2002 from
$23.7 million in the six months ended June 30, 2001. As a percentage of
revenues, general and administrative expenses decreased to 47.9% in the six
months ended June 30, 2002 from 59.0% in the six months ended June 30, 2001. The
decrease in absolute dollars was primarily due to a decrease of $5.1 million in
compensation and benefits costs as a result of reductions in headcount in
connection with our restructuring plan, a decrease of $2.0 million in travel and
entertainment and training costs also as a result of reductions in headcount, a
decrease of $1.7 million in bad debt expense, a decrease of $791,000 in
facilities and equipment leases, and a decrease of $1.2 million in professional
services and other administrative costs.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased 12.4% to
$1.5 million in the six months ended June 30, 2002 from $1.7 million in the six
months ended June 30, 2001. The decrease was primarily attributable to the
writeoff of property and equipment in connection with our restructuring plans.
INTANGIBLES AMORTIZATION. Amortization of intangibles decreased to $2.0 million
for the six months ended June 30, 2002 from $12.7 million for the six months
ended June 30, 2001. For the six months ended June 30, 2002, the amount
consisted of amortization for intangible assets deemed to have finite lives
pursuant to the provisions of SFAS 142 which was adopted effective January 1,
2002. Such intangible assets consisted of customer lists and developed
technology. Intangibles amortization for the six months ended June 30, 2001
consisted of amortization for all intangible assets, including goodwill,
assembled workforce and tradenames.
IMPAIRMENT OF INTANGIBLES. We adopted the provisions of SFAS 144 effective
January 1, 2002. Given the decline in revenues and our market capitalization,
the overall deterioration of market conditions in the enterprise sector and our
forecasted operating results for the foreseeable future, we reviewed our
long-lived assets for impairment as of June 30, 2002. Based on this review, we
recognized an impairment loss of $8.7 million to reduce the carrying value of
our finite lived intangible assets, consisting of customer lists and developed
technology.
IMPAIRMENT OF PROPERTY AND EQUIPMENT. We adopted the provisions of SFAS 144
effective January 1, 2002. Given the decline in revenues and our market
capitalization, the overall deterioration of market conditions in the enterprise
sector, and our forecasted operating results for the foreseeable future, we
reviewed our long-lived assets for impairment as of June 30, 2002. Based on this
review, we recognized an impairment loss of $4.5 million to reduce the carrying
value of our property and equipment, consisting of computer equipment, furniture
and fixtures, capitalized software and leasehold improvements.
RESTRUCTURING AND OTHER CHARGES. For the six months ended June 30, 2002, we
recorded restructuring charges of $4.2 million in connection with our 2002
restructuring plan. Such charges consisted of $2.1 million in severance benefits
and other related expenses for a reduction in headcount of 106 employees and
$2.3 million in exit costs related to real estate and electronic equipment for
the closing of domestic offices. These charges were offset by $150,000 received
for equipment written off to restructuring charges in 2001 in connection with
the outsourcing of the our monitoring services provided as part of the Managed
Security Services division. For the six months ended June 30, 2001, we recorded
restructuring charges of $3.3 million in connection with our 2001 restructuring
plan. Such charges consisted of $1.9 million in severance benefits and other
related expenses for a reduction in headcount of 138 employees and $1.4 million
in exit costs related to real estate and electronic equipment. Additionally
included in the financial statement caption for the three months ended June 30,
2001 is $1.0 million related to the write-off of internal software management
tools that no longer suit our business needs.
LOSS ON LONG-TERM INVESTMENT IN RELATED PARTY. On March 22, 2001, Paradigm4,
Inc. filed for federal bankruptcy protection. This action created significant
uncertainty regarding our investment in Paradigm4. As a result, we recognized a
loss on our $1.0 million investment in Paradigm4 for the six months ended June
30, 2001.
NONCASH COMPENSATION EXPENSE. During 1999, we granted options to purchase shares
of common stock at exercises prices that were less than the fair market value of
the underlying shares of common stock, resulting in deferred compensation.
During 2000, in connection with our acquisitions of Synet and Global Integrity,
we issued options to Synet and Global Integrity optionholders in exchange for
their Synet and Global Integrity options, respectively. The unvested portion of
the Synet and Global Integrity options resulted in deferred compensation. These
transactions result in noncash compensation expense over the period that these
specific options vest. During the six months ended June 30, 2002 and 2001, we
recorded approximately $73,000 and $218,000, respectively, of noncash
compensation expenses related to these options. The decrease in noncash
compensation expense is a result of the cancellation of options as a result of
reductions in headcount in connection with our restructuring plans.
OTHER INCOME (EXPENSE). Other expense for the six months ended June 30, 2002
primarily consisted of the write-off of approximately $1.5 million of inventory
held for resale which was no longer deemed saleable. As the Company is acting as
an agent of the supplier in the arrangement for the resale of this inventory and
the revenues are recognized on a net basis, such write-off has been classified
as other expense. Other income for the six months ended June 30, 2001 primarily
consisted of interest income.
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE. Upon adoption of SFAS 142,
we recorded a noncash charge of $23.3 million to reduce the carrying value of
our goodwill and other indefinite lived intangible assets, primarily consisting
of acquired tradenames.
LIQUIDITY AND CAPITAL RESOURCES. Since inception, we have financed our
operations through borrowings under short-term credit facilities, the sale of
equity securities and cash flows from operations. As of June 30, 2002, we had
approximately $23.3 million in cash and cash equivalents and $1.3 million in
restricted cash pursuant to certain operating lease agreements.
Net cash used in operating activities increased to $18.3 million for the six
months ended June 30, 2002 from $17.4 million for the six months ended June 30,
2001. We experienced a decrease in accounts payable and accrued expenses and
other current liabilities of approximately $5.2 million. Such decrease included
approximately $2.4 million paid for the purchase of software inventory for
resale, approximately $982,000 for the payment of retention bonuses to former
employees of Global Integrity prior to the acquisition who met their one year
anniversary to qualify, and approximately $625,000 in lease termination fees for
office space restructured in 2001. We also experienced an increase in restricted
cash of $559,000 related to a new equipment operating lease entered into in the
first quarter of 2002. These net outflows of cash were offset by net inflows of
cash as a result of decreases in accounts receivable and unbilled receivables of
approximately $1.1 million. The decrease in accounts receivable was primarily
attributable to increased collection efforts and declining revenues due to
difficult market conditions.
Net cash used in investing activities was $790,000 and $5.3 million,
respectively, for the six months ended June 30, 2002 and 2001. Capital
expenditures were $810,000 for the six months ended June 30, 2002 and primarily
consisted of computer equipment and leasehold improvements. Capital expenditures
were $5.1 million for the six months ended June 30, 2001 and consisted of
computer equipment, office furniture, capitalized software and leasehold
improvements in connection with the investment in our infrastructure.
Net cash provided by financing activities was $903,000 and $1.7 million,
respectively, for the six months ended June 30, 2002 and 2001. Cash provided by
financing activities primarily resulted from the receipt of proceeds from the
exercise of options and the sale of common stock in connection with our Employee
Stock Purchase Plan.
We have a demand loan facility, secured by a lien on all of our assets, under
which we may borrow up to the lesser of $5.0 million or 80.0% of our accounts
receivable. At June 30, 2002 the amount available under the facility was $5.0
million. Amounts outstanding under the facility bear interest at the lender's
base rate which was 4.75% as of June 30, 2002.
Based on our current revenue projections, we believe that we will continue to be
cash flow negative for at least the next twelve months. We believe that our
existing cash, cash equivalents and marketable securities will be sufficient to
meet our anticipated needs for working capital and capital expenditures for at
least the next twelve months. If cash generated from operations is insufficient
to satisfy our liquidity requirements, we may seek to sell additional equity or
debt securities or to obtain a credit facility. The sale of additional equity or
convertible debt securities could result in dilution to our stockholders. The
incurrence of indebtedness would result in increased fixed obligations and could
result in operating covenants that would restrict our operations. We cannot
assure you that financing will be available in amounts or on terms acceptable to
us, if at all.
Recent Accounting Pronouncements
In July 2001, the FASB issued Statement of Financial Accounting Standards
No. 141, "Business Combinations" (SFAS 141) and No. 142, "Goodwill and Other
Intangible Assets" (SFAS 142). SFAS 141 requires all business combinations
initiated after June 30, 2001 to be accounted for using the purchase method of
accounting. Under SFAS 142, goodwill and intangible assets with indefinite lives
are no longer amortized but are reviewed annually (or more frequently if
impairment indicators arise) for impairment. Separable intangible assets that
are not deemed to have indefinite lives will continue to be amortized over their
useful lives (but with no maximum life). The amortization provisions of SFAS 142
apply to goodwill and intangible assets acquired after June 30, 2001. The
Company adopted the provisions of SFAS 142 effective January 1, 2002. As
required by the transitional provisions of SFAS 142, the Company evaluated
goodwill and intangible assets with indefinite lives for impairment as of
January 1, 2002. This evaluation was completed during the quarter ended June 30,
2002. As a result of this transitional testing, the Company recorded a noncash
impairment charge of $23,307,626 to reduce the carrying value of its goodwill
and other indefinite lived intangible assets. Such charge is reflected as a
cumulative effect of change in accounting principle in the accompanying
consolidated statements of operations for the six months ended June 30, 2002.
In July 2001, the FASB issued Statement of Financial Accounting Standard No.
143, "Accounting for Asset Retirement Obligations" (SFAS 143), which is
effective for fiscal years beginning after June 15, 2002. SFAS 143 requires,
among other things, the accounting and reporting of legal obligations associated
with the retirement of long-lived assets that result from the acquisition,
construction, development or normal operation of a long-lived asset. The Company
believes the adoption of SFAS 143 will not have a material impact on its
financial position or results of operations.
In August 2001, the FASB issued Statement of Financial Accounting Standard No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets" (SFAS
144). This statement supersedes Statement of Financial Accounting Standard No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" (SFAS 121) and Accounting Principles Board Opinion No.
30, "Reporting Results of Operations - Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions." The Statement retains the fundamental provisions of
SFAS 121 for recognition and measurement of impairment, but amends the
accounting and reporting standards for segments of a business to be disposed of.
The Company adopted the provisions of SFAS 144 effective January 1, 2002. Given
the decline in revenues and market capitalization of the Company and the overall
deterioration of market conditions in the enterprise sector, the Company
reviewed its long-lived assets for impairment as of June 30, 2002. Based on this
review, the Company recognized an impairment loss to reduce the carrying value
of its finite lived intangible assets and property and equipment of $8,743,545
and $4,510,193, respectively. Such charges are reflected in the accompanying
consolidated statements of operations for the three and six months ended June
30, 2002.
On November 14-15, 2001, the Emerging Issues Task Force (EITF) of the FASB
concluded that reimbursements received for "out-of-pocket" expenses should be
classified as revenue, and correspondingly cost of services, in the income
statement. This accounting treatment should be applied in financial reporting
periods (years) beginning as early as the March 2002 quarter. Upon application
of the pronouncement, comparative financial statements for prior periods must
also be reclassified in order to ensure consistency among all periods presented.
The Company adopted this pronouncement effective January 1, 2002 and has
separately disclosed the impact of adoption in the consolidated statements of
operations.
In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections."
This statement eliminates the automatic classification of gain or loss on an
extinguishment of debt as an extraordinary item of income and requires that such
gain or loss be evaluated for extraordinary classification under the criteria of
Accounting Principles Board No. 30 "Reporting Results of Operations." This
statement also requires sales-leaseback accounting for certain lease
modifications that have economic effects that are similar to sales-leaseback
transactions, and makes various other technical corrections to existing
pronouncements. This statement will be effective for the Company for the year
ending December 31, 2003. The Company is currently assessing, but has not yet
determined the effect, if any, of SFAS 145.
In July 2002, the Financial Accounting Standards Board issued SFAS No. 146,
"Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146
will supersede Emerging Issues Task Force Issue No. 94-3, "Liability Recognition
for Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." SFAS No. 146 requires
that costs associated with an exit or disposal plan be recognized when incurred
rather than at the date of a commitment to an exit or disposal plan. SFAS No.
146 is to be applied prospectively to exit or disposal activities initiated
after December 31, 2002. The Company is currently assessing, but has not yet
determined the effect, if any, of SFAS 146.
RISK FACTORS
An investment in our company involves a high degree of risk. You should
carefully consider the risks described below before you decide to buy our common
stock. If any of the following risks actually occur, our business, results of
operations or financial condition would likely suffer. In this case, the trading
price of our common stock could decline.
Risks Related to Our Financial Condition and Business Model
Our limited operating history makes it difficult for you to evaluate our
business and to predict our future success
We commenced operations in February 1995 and therefore have only a
limited operating history for you to evaluate our business. Because of our
limited operating history and the fact that many of our competitors have longer
operating histories, we believe that the prediction of our future success is
difficult. You should evaluate our chances of financial and operational success
in light of the risks, uncertainties, expenses, delays and difficulties
associated with operating a new business, many of which are beyond our control.
You should not rely on our historical results of operations as indications of
future performance. The uncertainty of our future performance and the
uncertainties of our operating in a new and volatile market increase the risk
that the value of your investment will decline.
Adverse market conditions, particularly those affecting the professional
services industry, may impair our operating results
Our results depend to a large extent on market conditions affecting the
technology industry in general and the telecommunications and enterprise sectors
in particular. Adverse market conditions in the sectors in which we operate
could delay buying decisions or cause projects to be deferred, reduced in scope
or discontinued. These sectors are experiencing a drastic downturn. We can not
predict how long this contraction will last, or the timing or strength of a
recovery, if any. If market conditions and corporate spending in these sectors
do not improve, our operating results will continue to suffer.
Because most of our revenues are generated from a small number of clients, our
revenues are difficult to predict and the loss of one client could significantly
reduce our revenues
During the six months ended June 30, 2002, BellSouth Corporation
accounted for approximately 16.7% of our revenues. Our five largest clients
accounted for approximately 44.9% of our revenues for the six months ended June
30, 2002. For the year ended December 31, 2001, our five largest clients
accounted for approximately 40.6% of our revenues. If one of our major clients
discontinues or significantly reduces the use of our services, we may not
generate sufficient revenues to offset this loss of revenues and our net loss
will increase. In addition, the non-payment or late payment of amounts due from
a major client could adversely affect us. As of June 30, 2002, the accounts
receivable from BellSouth was approximately $1.2 million, which related to work
performed in April through June 2002.
Our clients may terminate their contracts with us on short notice
Our services are often delivered pursuant to short-term arrangements
and most clients can reduce or cancel their contracts for our services without
penalty and with little or no notice. If a major client or a number of small
clients terminate our contracts or significantly reduce or modify their business
relationships with us, we may not be able to replace the shortfall in revenues.
Consequently, you should not predict or anticipate our future revenues based
upon the number of clients we have currently or the number and size of our
existing projects.
Our operating results may vary from quarter to quarter in future periods, and as
a result, we may fail to meet the expectations of our investors and analysts,
which may cause our stock price to fluctuate or decline
Our operating results have varied from quarter to quarter. Our operating
results may continue to vary as a result of a variety of factors. These factors
include:
o the loss of key employees;
o the development and introduction of new service offerings;
o reductions in our billing rates;
o the miscalculation of resources required to complete new or ongoing
projects;
o the utilization of our workforce;
o the ability of our clients to meet their payments obligations to us;
and
o the timing and extent of training.
Many of these factors are beyond our control. Accordingly, you should not
rely on quarter-to-quarter comparisons of our results of operations as an
indication of our future performance. In addition, our operating results may be
below the expectations of public market analysts or investors in some future
quarter. If this occurs, the price of our common stock is likely to decline.
We derive a substantial portion of our revenues from fixed-price projects, under
which we assume greater financial risk if we fail to accurately estimate the
costs of the projects
We derive a substantial portion of our revenues from fixed-price
projects. For the six months ended June 30, 2002 and the year ended December 31,
2001, fixed-price projects accounted for 40.4% and 48.2% of our revenue,
respectively. We assume greater financial risks on a fixed-price project than on
a time-and-expense based project. If we miscalculate the resources or time we
need for these fixed-price projects, the costs of completing these projects may
exceed the price, which could result in a loss on the project and a increase in
net loss. We recognize revenues from fixed-price projects based on our estimate
of the percentage of each project completed in a reporting period. To the extent
our estimates are inaccurate, the revenues and operating profits, if any, that
we report for periods during which we are working on a fixed-price project may
not accurately reflect the final results of the project and we would be required
to record an expense for these periods equal to the amount by which our revenues
were previously overstated.
Our operating results may fluctuate due to seasonal factors which could result
in greater than expected losses
Our results of operations may experience seasonal fluctuations as
businesses typically spend less on network management services during the summer
and year-end vacation and holiday periods. Additionally, as a large number of
our employees take vacation during these periods, our utilization rates during
these periods tend to be lower, which reduces our margins and operating income.
Accordingly, we may report greater than expected losses for these periods.
Our long sales cycle makes our revenues difficult to predict and could cause our
quarterly operating results to be below the expectations of public market
analysts and investors
The timing of our revenues is difficult to predict because of the
length and variance of the time required to complete a sale. Before hiring us
for a project, our clients often undertake an extensive review process and may
require approval at various levels within their organization. Any delay due to a
long sales cycle could reduce our revenues for a quarter and cause our quarterly
operating results to be below the expectations of public market analysts or
investors. If this occurs, the price of our common stock is likely to decline.
We may need to raise additional capital to grow our business, which we may not
be able to do
Our future liquidity and capital requirements are difficult to predict
because they depend on numerous factors, including the success of our existing
and new service offerings and competing technological and market developments.
As a result, we may not be able to generate sufficient cash from our operations
to meet additional working capital requirements, support additional capital
expenditures or take advantage of acquisition opportunities. Accordingly, we may
need to raise additional capital in the future. Our ability to obtain additional
financing will be subject to a number of factors, including market conditions,
our operating performance and investor sentiment. These factors may make the
timing, amount, terms and conditions of additional financing unattractive for
us. If we are unable to raise additional funds when needed, our ability to
operate and grow our business could be impeded.
Risks Related to Our Strategy and Market
We may have difficulty managing our expanding operations, which may harm our
business
A key part of our strategy is to grow our business; however, our rapid
growth has placed a significant strain on our managerial and operational
resources. From January 1, 1999 to December 31, 2000, our headcount increased
from approximately 138 to approximately 691 employees. Since such time, as a
result of market conditions and other factors, we have decreased our headcount
to 342 employees as of June 30, 2002. As a result of this reduction, the
remaining employees have been charged with additional responsibilities. To
manage our growth, we must continue to improve our financial and management
controls, reporting systems and procedures, and expand and train our work force.
We may not be able to do so successfully.
The workforce restructuring we have taken in response to the recent slowdown in
demand for our services could have adverse effects on our business.
Our business has been experiencing lower revenues due to decreased
customer demand for our services. To scale back our operations and to reduce our
expenses in response to this decreased demand for our services, we have
significantly reduced the size of our workforce. While these actions have
positively impacted our results of operations, there are several risks inherent
in our efforts to transition to a smaller workforce. Reducing the size of our
workforce could have adverse effects on our business by reducing our pool of
technical talent, making it more difficult for us to respond to customers,
limiting our ability to provide increased services quickly if and when the
demand for our services increases, and limiting our ability to hire and retain
key personnel. These circumstances could cause our earnings to be lower than
they might otherwise be.
Our management team has experienced significant turnover which could interrupt
our business and adversely affect our growth
Our future success depends, in significant part, upon the continued
service and performance of our senior management and other key personnel. Neeraj
(Berry) Sethi was appointed our acting Chief Financial Officer in May 2002. In
addition, in connection with our recent reductions in staff, many members of our
senior management team have either departed, or been redeployed and given new
responsibilities. If the restructuring of our senior management team does not
lead to the results we expect, our ability to effectively deliver our services,
manage our company and carry out our business plan may be impaired.
We may not be able to hire and retain qualified network systems and security
consultants which could affect our ability to compete effectively
Our continued success depends on our ability to identify, hire, train
and retain highly qualified network and security management consultants. These
individuals are in high demand and we may not be able to attract and retain the
number of highly qualified consultants that we need. If we cannot retain,
attract and hire the necessary consultants, our ability to grow, complete
existing projects and bid for new projects will be adversely affected.
Competition in the network and security consulting industry is intense, and
therefore we may lose projects to our competitors
Our market is intensely competitive, highly fragmented and subject to
rapid technological change. We expect competition to intensify and increase over
time. We may lose projects to our competitors, which could adversely affect our
business, results of operations and financial condition. In addition,
competition could result in lower billing rates and gross margins and could
require us to increase our spending on sales and marketing.
We face competition from systems integrators, value added resellers,
network services firms, security consulting firms, telecommunications providers,
and network equipment and computer systems vendors. These competitors may be
able to respond more quickly to new or emerging technologies and changes in
client requirements or devote greater resources to the expansion of their market
share.
Additionally, our competitors have in the past and may in the future
form alliances with various network equipment vendors that may give them an
advantage in implementing networks using that vendor's equipment.
We also compete with internal information technology departments of
current and potential clients. To the extent that current or potential clients
decide to satisfy their needs internally, our business will suffer.
If we are unable to find suitable acquisition candidates, our growth could be
impeded
A component of our growth strategy is the acquisition of, or investment
in, complementary businesses, technologies, services or products. Our ability to
identify and invest in suitable acquisition and investment candidates on
acceptable terms is crucial to this strategy. We may not be able to identify,
acquire or make investments in promising acquisition candidates on acceptable
terms. Moreover, in pursuing acquisition and investment opportunities, we may be
in competition with other companies having similar growth and investment
strategies. Competition for these acquisitions or investment targets could also
result in increased acquisition or investment prices and a diminished pool of
businesses, technologies, services or products available for acquisition or
investment.
Our acquisition strategy could have an adverse effect on client satisfaction and
our operating results
Acquisitions, including those already consummated, involve a number of
risks, including:
o integrating the acquired company into our existing business;
o adverse effects on our reported operating results due to accounting
charges associated with acquisitions;
o increased expenses, including compensation expense resulting from
newly hired employees; and
o potential disputes with the sellers of acquired businesses,
technologies, services or products.
Client dissatisfaction or performance problems with an acquired business,
technology, service or product could also have a material adverse impact on our
reputation as a whole. In addition, any acquired business, technology, service
or product could significantly underperform relative to our expectations.
Competition for experienced personnel is intense and our inability to retain key
personnel could interrupt our business and adversely affect our growth
Our future success depends, in significant part, upon the continued
service and performance of our senior management and other key personnel. Losing
the services of any of these individuals may impair our ability to effectively
deliver our services and manage our company, and to carry out our business plan.
In addition, competition for qualified personnel in the network and security
consulting industry is intense and we may not be successful in attracting and
retaining these personnel. There may be only a limited number of persons with
the requisite skills to serve in these positions and it may become increasingly
difficult to hire these persons. Our business will suffer if we encounter delays
in hiring additional personnel.
Our business may suffer if we fail to adapt appropriately to the challenges
associated with operating internationally
Operating internationally may require us to modify the way we conduct
our business and deliver our services in these markets. We anticipate that we
will face the following challenges internationally:
o the burden and expense of complying with a wide variety of foreign
laws and regulatory requirements;
o potentially adverse tax consequences;
o longer payment cycles and problems in collecting accounts receivable;
o technology export and import restrictions or prohibitions;
o tariffs and other trade barriers;
o difficulties in staffing and managing foreign operations;
o cultural and language differences;
o fluctuations in currency exchange rates; and
o seasonal reductions in business activity during the summer months in
Europe.
If we do not appropriately anticipate changes and adapt our practices to
meet these challenges, our growth could be impeded and our results of operations
could suffer.
If we do not keep pace with technological changes, our services may become less
competitive and our business will suffer
Our market is characterized by rapidly changing technologies, frequent
new product and service introductions, and evolving industry standards. As a
result of the complexities inherent in today's computing environments, we face
significant challenges in remaining abreast of such changes and product
introductions. If we cannot keep pace with these changes, we will not be able to
meet our clients' increasingly sophisticated network management and security
needs and our services will become less competitive.
Our future success will depend on our ability to:
o keep pace with continuing changes in industry standards, information
technology and client preferences;
o respond effectively to these changes; and
o develop new services or enhance our existing services.
We may be unable to develop and introduce new services or enhancements to
existing services in a timely manner or in response to changing market
conditions or client requirements.
If the use of large-scale, complex networks does not continue to grow, we may
not be able to successfully increase or maintain our client base and revenues
To date, a majority of our revenues have been from network management
and security services related to large-scale, complex networks. We believe that
we will continue to derive a majority of our revenues from providing network
design, performance, management and security services. As a result, our future
success is highly dependent on the continued growth and acceptance of
large-scale, complex computer networks and the continued trend among our clients
to use third-party service providers. If the growth of the use of enterprise
networks does not continue or declines, our business may not grow and our
revenues may decline.
Risks Related to Intellectual Property Matters and Potential Legal Liability
Unauthorized use of our intellectual property by third parties may damage our
brand
We regard our copyrights, trade secrets and other intellectual property
as critical to our success. Unauthorized use of our intellectual property by
third parties may damage our brand and our reputation. We rely on trademark and
copyright law, trade secret protection and confidentiality and/or license and
other agreements with our employees, customers, partners and others to protect
our intellectual property rights. However existing trade secret, trademark and
copyright laws afford us only limited protection. Despite our precautions, it
may be possible for third parties to obtain and use our intellectual property
without our authorization. The laws of some foreign countries are also uncertain
or do not protect intellectual property rights to the same extent as do the laws
of the United States.
We may have to defend against intellectual property infringement claims, which
could be expensive and, if we are not successful, could disrupt our business
We cannot be certain that our services, the finished products that we
deliver or materials provided to us by our clients for use in our finished
products do not or will not infringe valid patents, copyrights, trademarks or
other intellectual property rights held by third parties. As a result, we may be
subject to legal proceedings and claims from time to time relating to the
intellectual property of others in the ordinary course of our business. We may
incur substantial expenses in defending against these third-party infringement
claims, regardless of their merit. Successful infringement claims against us may
result in substantial monetary liability and materially disrupt the conduct of
our business.
Because our services are often critical to our clients' operations, we may be
subject to significant claims if our services do not meet our clients
expectations
Many of our projects are critical to the operations of our clients'
businesses. If we cannot complete these projects to our clients' expectations,
we could materially harm our clients' operations. This could damage our
reputation, subject us to increased risk of litigation or result in our having
to provide additional services to a client at no charge. Although we carry
general liability insurance coverage, our insurance may not cover all potential
claims to which we are exposed or may not be adequate to indemnify us for all
liability that may be imposed.
Our stock price is likely to be highly volatile and could drop unexpectedly
The market price of our common stock is highly volatile, has fluctuated
substantially and may continue to do so. As a result, investors in our common
stock may experience a decrease in the value of their common stock regardless of
our operating performance or prospects. In addition, the stock market has, from
time to time, experienced significant price and volume fluctuations that have
affected the market prices for the securities of technology companies. In the
past, following periods of volatility in the market price of a particular
company's securities, securities class action litigation was often brought
against that company. Many technology-related companies have been subject to
this type of litigation. We are currently involved in this type of litigation.
Litigation is often expensive and diverts management's attention and resources.
Our common stock could be delisted from the Nasdaq National Market
Our common stock trades on the Nasdaq National Market, which specifies
certain requirements for continued listing of common stock. One of the
requirements is that the minimum closing bid price per share of our common stock
not be less than $1.00 for a period of 30 consecutive trading days. On July 25,
2002, we received notice from Nasdaq that for the prior 30 consecutive trading
days the minimum closing bid price per share of our common stock was less than
$1.00 and, in the event we do not regain compliance by October 23, 2002, Nasdaq
will delist our common stock from the Nasdaq National Market.
There can be no assurance that we will satisfy the requirements for
continued listing on the Nasdaq National Market. If we do not satisfy these
requirements, our common stock will be delisted. If our common stock is
delisted, we may be unable to have our common stock listed or quoted on any
other organized market. Even if our common stock is quoted or listed on another
organized market, an active trading market may not develop.
Delisting from the Nasdaq National Market would likely make it more
difficult for us to raise capital in the future. Delisting could also reduce the
ability of holders of our common stock to purchase or sell shares as quickly and
as inexpensively as they have done historically. Delisting could have an adverse
effect on the trading price of our common stock, regardless of our actual
operating performance. Delisting could also adversely affect our relationships
with vendors and customers, and may subject our common stock to the "penny stock
rules" contained in Section 15(g) of the Securities Exchange Act of 1934.
We are controlled by a small group of our existing stockholders, whose interests
may differ from other stockholders
Our directors, executive officers and affiliates currently beneficially
own approximately 29% of the outstanding shares of our common stock.
Accordingly, these stockholders will have significant influence in determining
the outcome of any corporate transaction or other matter submitted to the
stockholders for approval, including mergers, acquisitions, consolidations and
the sale of all or substantially all of our assets, and also the power to
prevent or cause a change in control. The interests of these stockholders may
differ from the interests of the other stockholders.
Our charter documents and Delaware law may inhibit a takeover that stockholders
may consider favorable
Provisions in our charter and bylaws may have the effect of delaying or
preventing a change of control or changes in our management that stockholders
consider favorable or beneficial. If a change of control or change in management
is delayed or prevented, the market price of our common stock could decline.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Currency Rate Fluctuations.
Our results of operations, financial position and cash flows are not materially
affected by changes in the relative values of non-U.S. currencies to the U.S.
dollar. We do not use derivative financial instruments to limit our foreign
currency risk exposure.
Market Risk.
Our accounts receivable are subject, in the normal course of business, to
collection risks. We regularly assess these risks and have established policies
and business practices to protect against the adverse effects of collection
risks. As a result, we do not anticipate any material losses in this area.
Interest Rate Risks.
We do not currently have any outstanding indebtedness. In addition, our
investments are classified as cash and cash equivalents with original maturities
of three months or less. Therefore, we are not exposed to material market risk
arising from interest rate changes, nor do such changes affect the value of
investments as recorded by us.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Except as set forth below, we are not a party to any material legal proceedings.
On November 13, 2001, a securities class action complaint was filed in
the United States District Court for the Southern District of New York against
Predictive, four investment banks that underwrote the Company's initial public
offering, and three of the Company's former officers and directors. This action
has been coordinated with over three hundred virtually identical actions against
other companies and the investment banks that underwrote their initial public
offerings. The complaint filed against Predictive generally alleged that the
underwriters obtained excessive and undisclosed commissions from customers who
received allocations of shares in the Company's initial and secondary public
offerings and that the underwriters maintained artificially inflated prices in
the after market through "tie-in" arrangements, which required customers to buy
additional shares of the Company's stock at pre-determined prices in excess of
the offering prices. The complaint further alleged that the Company and certain
of its officers and directors violated Sections 11, 12(a)(2) and 15 of the
Securities Act of 1933 because the Company's registration statement did not
disclose the underwriters' purported misconduct. On April 20, 2002, the
plaintiffs amended their complaint, abandoning the Section 12(a)(2) claim, but
alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act,
and of Rule 10b-5 promulgated thereunder. Plaintiffs seek an unspecified amount
of damages on behalf of persons who purchased the Company's stock pursuant to
the registration statements. The Company believes that the allegations against
it are without merit and intends to defend the case vigorously.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
NONE.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
NONE.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
NONE.
ITEM 5. OTHER INFORMATION
NONE.
ITEM 6. EXHIBITS AND REPORT ON FORM 8-K
(a) The following exhibits are filed as part of this report:
10.1 Consulting Agreement, dated June 27, 2002, by and between the Registrant
and Meyer Capital Partners LLC.
99.1 Certification under Section 906 of the Sarbanes-Oxley Act.
(b) The Company filed two reports on Form 8-K during the three months ended
June 30, 2002 and one report filed after June 30, 2002 through the date hereof.
Information regarding the items reported on is as follows:
May 13, 2002. The Company announced that Rod Dorsey, its Chief Financial
Officer, had resigned and that Neeraj Sethi had joined the Company as acting
Chief Financial Officer.
May 30, 2002. The Company announced that it had dismissed Arthur Andersen LLP as
its principal accountants and that Deloitte & Touche LLP was retained as the
Company's principal accountants.
July 23, 2002. The Company announced that Braden Kelly had resigned from its
Board of Directors.
ITEM 7. SIGNATURES
Pursuant to the requirements of the Securities Exchange Act, the Registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
PREDICTIVE SYSTEMS, INC.
(Registrant)
Date: August 14, 2002 /s/ ANDREW ZIMMERMAN
--------------------------------------------------------------------------------
Name: Andrew Zimmerman
Title: Chief Executive Officer
(principal executive officer)
Date: August 14, 2002 /s/ NEERAJ SETHI
--------------------------------------------------------------------------------
Name: Neeraj Sethi
Title: Acting Chief Financial Officer
(principal accounting and financial officer)