UNITED STATES SECURITIES AND EXCHANGE
COMMISSION
WASHINGTON, D.C. 20549
----------------------
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002
Commission file number 000-30422
PREDICTIVE SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
DELAWARE 13-3808483
(State of incorporation) (I.R.S. Employer
Identification Number)
--------------------
19 West 44th Street, 9th Floor
New York, New York 10036
(212) 659-3400
(Address, including zip code, and telephone number, including area code, of
Registrant's principal executive offices)
http://www.predictive.com
(Registrant's URL)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock Par
Value $0.001 Per Share
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 of 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. |X| Yes |_| No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |X|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). |_| Yes |X| No
The aggregate market value of voting stock held by non-affiliates of the
registrant as of the last business day of the registrant's most recently
completed second fiscal quarter was $8,282,944 (based on the last reported sale
price on the NASDAQ SmallCap Market on that date).
The number of shares outstanding of the registrant's common stock as of March
27, 2003 was 38,158,107.
DOCUMENTS INCORPORATED BY REFERENCE
The following documents (or parts thereof) are incorporated by reference into
the following parts of this Form 10-K: Portions of the Registrant's Definitive
Proxy Statement for the 2003 Annual Meeting of Stockholders, or if no such proxy
statement is filed with the Securities and Exchange Commission by April 30,
2003, an amendment to this Annual Report on Form 10K, are incorporated by
reference into Part III of this Report.
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TABLE OF CONTENTS
Page
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PART I
Item 1. Business. ........................................... 4
Item 2. Properties .......................................... 16
Item 3. Legal Proceedings. .................................. 17
Item 4. Submission of Matters to a Vote of Security Holders. 17
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters................................. 18
Item 6. Selected Consolidated Financial Data ................ 20
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations. ................ 21
Item 7A. Quantitative and Qualitative Disclosures about
Market Risk. ........................................ 39
Item 8. Financial Statements and Supplementary Data. ........ 39
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure ................. 75
PART III
Item 10. Directors and Executive Officers of the Registrant. . 76
Item 11. Executive Compensation. ............................. 76
Item 12. Security Ownership of Certain Beneficial Owners and
Management.......................................... 76
Item 13. Certain Relationships and Related Transactions. ..... 76
Item 14. Controls and Procedures .............................. 76
Item 15. Exhibits, Financial Statement Schedules and Reports
on Form 8-K......................................... 76
SIGNATURES. ....................................................... 79
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FORWARD LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995 that
involve risks, uncertainties and assumptions that, if they never materialize or
if they prove incorrect, could cause our results to differ materially from those
expressed or implied by such forward-looking statements. All statements other
than statements of historical fact are statements that could be deemed
forward-looking, including statements pertaining to: our revenue, earnings, cash
flow and liquidity; our strategy relating to network technologies; the
industries in which we operate; our product development plans and investments;
future acquisitions; international operations; cost savings arising from our
restructurings; and legal proceedings and litigation matters. You can identify
these and other forward-looking statements by the use of words such as "may,"
"will," "should," "expects," "plans," "anticipates," "believes," "estimates,"
"predicts," "intends," "potential," "continue" or the negative of such terms, or
other comparable terminology. Forward-looking statements also include the
assumptions underlying or relating to any of the foregoing statements. Our
actual results could differ materially from those anticipated in these
forward-looking statements as a result of various factors, including those set
forth in this Annual Report under the heading "Risk Factors." All
forward-looking statements included in this document are based on information
available to us on the date hereof. We will not undertake and specifically
decline any obligation to update any forward-looking statements.
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PART I
Item 1. Business
Overview
We are a leading independent network infrastructure and security
consulting company focused on helping global enterprises and service providers
harness the power of network technology. Specifically, we build, optimize, and
secure high-performance infrastructures that deliver measurable results by
increasing operational efficiency, mitigating risk, and empowering our Fortune
1000 clients' business initiatives. Our BusinessFirst(TM) approach ensures that
we deliver measurable, sustainable results to clients that allow them to benefit
from our collective, in-depth experience. With BusinessFirst, we prioritize a
client's goals and deliver business-driven solutions. Our expertise spans a
multitude of disciplines including enterprise management, performance, network
design, and management and information security. We believe that this range of
services along with our business-oriented approach is unique in the industry.
As an independent service provider, we provide our clients with
unbiased expertise that enables the design, implementation and management of
optimal technology solutions. We provide our services on either a project
outsource or collaborative consulting basis. Our project outsource services are
based on and measured against mutually agreed upon service offerings and provide
our clients with certainty of costs, delivery time and project scope. Our
collaborative consulting services enable our clients to utilize our extensive
expertise in order to extend their internal capabilities and to access our
methodologies. Our service offerings cover the cornerstones of network
technology: network design and engineering; enterprise management (including
network management, asset management, performance management and service
management); and information security. This structure enables us to gain
in-depth expertise and become familiar with the best practices and methodologies
identified within each of those disciplines.
Industry Background
Over the past few years, a number of trends have emerged that begin to
push the envelope of the current iteration of corporate networks. The developing
concept of "pervasive computing," based heavily on personal digital assistants
(PDAs), Web-enabled phones, and other appliance-type devices, coupled with the
increasing adoption of the concept that computer networks should be viewed as a
utility, have begun to push the limits of the current generation of security and
network management models.
Whereas networks have traditionally been built around the notion of
physical environments, in which users and data were often co-located, we believe
future networks are likely to be more "transparent"; that is, networks will be
architected around the location of data and applications, as opposed to
individual users or machines. In addition, organizations must adapt their
current security models to be more flexible and configurable, without
compromising the strength of the security provided. This new concept of
"transparent networking" creates a new set of issues for large corporations:
o Networks must support wireless clients of a heterogeneous nature.
o Networks must support users in geographically disparate locations, all
around the world.
o Corporations must be able to centrally manage and maintain network
components that are in physically distant locations, and that may be
run by third-parties.
o Service level agreements (SLAs) must be adapted and strengthened to
apply to highly distributed control environments.
o Customer environments must be able to create highly-personalized client
experiences, and networks must be able to support those abstract
personalized experiences in the physical network.
o Organizations must have the ability to control and manage large numbers
of assets in widespread environments.
o Organizations must develop, deploy, and manage highly-flexible,
dynamically-configurable, and strong security models that fit the
transparent environment.
However, we believe that few firms have the requisite focus and
expertise to address these issues, and that many are limited by the fact that
they:
o are primarily motivated by distributing their own products and often
lack the skills to implement multi-vendor solutions;
o do not have the breadth of capabilities in networking, security and
enterprise management to address the issues raised by transparent
networking;
o are focused on traditional mainframe computing environments and derive
a large percentage of their revenue from reselling hardware and
software products; or
o only augment businesses' in-house capabilities with hourly rate-based
teams of technical personnel.
4
The Predictive Solution
We are a leading network infrastructure and security consulting company
that builds, optimizes, and secures high-performance infrastructures that
deliver measurable results by increasing operational efficiency, mitigating risk
and empowering our Fortune 1000 clients' business initiatives. Predictive
Systems' BusinessFirst(TM) approach is the core value that underpins everything
we do, motivating our consultants to understand each client's business and to
design and build network infrastructures that support and enhance that business.
We employ our BusinessFirst approach on all engagements in order to ensure that
our network technology and security solutions not only meet our clients'
business objectives, but also bring tangible business benefits. BusinessFirst
reflects our inherent belief that a client's infrastructure is a
mission-critical asset. We are dedicated to understanding both prevalent and
cutting-edge technologies to provide us with relevant and specific technical
knowledge. We believe that our success to date has been largely attributable to
the following key characteristics of our service offerings:
Business-driven, Results-Oriented Approach. Using our proprietary
Business Analysis methodology, Operational Risk capabilities, Business Process
Engineering teams and our structured Program and Project Management teams, we
can demonstrate the business value of technology solutions in specific and
measurable terms, thereby enabling our clients to incorporate objective and
quantifiable analysis into their technology investment decisions. We provide our
clients with a detailed analysis of the financial benefit of a project by
quantifying factors such as business risks, total cost of ownership and
operational efficiency. As a result, our clients can gain a clear understanding
of the benefits that they will derive from their network technology and security
investments and a measure of certainty about how their technology investments
will be translated into tangible and measurable improvements to their business
processes.
Fixed-Price, Fixed-Time Engagement Model. We provide our clients with a
service delivery model that is designed to enhance their ability to
cost-effectively leverage our expertise. When engaged on a project outsource
basis, we work with our clients to mutually define a fixed scope of work at the
beginning of the project that is tailored to the clients' specific needs and
therefore, modified from engagement to engagement. We then deliver the services
for a fixed fee, in a fixed period of time with a fixed set of deliverables.
In-Depth Network Infrastructure and Security Expertise. Our consultants
are organized into disciplines that span the cornerstones of network
infrastructure and security: network design and engineering; Global Integrity
Security; network and systems management; integrated customer service and
performance management. This enables our consultants to gain in-depth expertise
and become intimately familiar with the best practices within each of those
disciplines. More importantly, it enables us to leverage the knowledge base
within each practice group to provide our clients with cross-functional teams of
consultants that are better equipped to address their varying needs in a
coordinated and efficient manner.
Strategy
Continue to Attract and Retain Highly Qualified Consultants. We intend
to continue to attract and retain highly qualified consultants by providing them
with a rich environment and culture in which to work, and by offering them
attractive professional development and compensation opportunities. We generally
recruit consultants who have significant technical expertise and offer them the
ability to accelerate their career development by working with sophisticated
technologies in complex, multi-vendor environments. We have established a formal
training program which is designed to improve the skills and productivity of our
consultants. We intend to continue to promote our corporate culture with stated
values and invest in the training and development of our consultants.
Further Increase Our Industry Expertise. We intend to continue to
expand the scope of our industry expertise in order to further penetrate the
markets in which we serve. We believe our expertise in specific industries
considerably enhances our ability to help companies within those industries gain
competitive advantage by improving the performance, utility and security of
their networks. We have significant experience within the financial services,
telecommunication services, oil/gas and Internet and electronic commerce
industries. In each of these markets, we employ industry experts, pursue
targeted sales and marketing opportunities and develop industry-specific service
offerings. We intend to expand into other industries which we believe will be
well suited to our services.
Cross-Sell into Existing Accounts and Deepen Existing Relationships.
Over the years, we have cultivated and grown client relationships with many of
the largest companies in the world. In many cases, however, these relationships
may only be based on a small subset of services currently (or previously)
contracted to Predictive. However, we believe that these clients would be
receptive to a broader range of services to address a number of their technology
infrastructure needs.
Establish Additional and Broaden Existing Strategic Relationships. We
have developed a number of strategic relationships, including alliances with
Cisco Systems, InfoVista , Micromuse, SMARTS and Symantec, and. Under these
relationships, our partners recommend or directly resell our services to their
clients. We intend to continue to expand the scope of these relationships and to
develop new strategic alliances to further broaden the indirect sales channel
for our services.
5
Services
Our service offerings are grouped into three major areas: Networking,
Enterprise Management, and Information Security. Our consultants are further
organized into different disciplines. Although many of our consultants are
cross-skilled in a variety of technologies and many technologies span multiple
disciplines, each discipline represents an aspect of network technology
important enough to warrant specialization.
These five disciplines are:
o network design and engineering;
o network and systems management;
o integrated customer service;
o performance management; and
o Global Integrity Security.
Our consultants have extensive experience with a wide variety of
technologies and vendors. For some clients, our consultants are involved in both
technology and vendor selection. Other clients have already selected the
technology, vendor or both. Regardless, we offer our clients a completely
objective, vendor-neutral approach. Our knowledge of advanced technologies and
leading vendors is a significant part of our value proposition to our clients.
Network Design and Engineering. Our network design and engineering
discipline is dedicated to helping our clients plan, implement and operate
business networks and network services. Our real-world experience and
cross-discipline collaboration produces network systems that are cost-effective,
manageable, scalable and secure. This enables our clients to use technology to
gain a major competitive advantage and a tangible return on investment.
The following table lists some of the services provided by our network
design and engineering discipline area:
Service Description
------------------------------------------------- -------------------------------------------------
Network Operations Assessments................... Assess the ability of an organization's network to
support its business strategy. Includes an analysis
of the network's performance, capacity, security,
availability and disaster scenarios.
Virtual Private Network and Access Solutions..... Designs and deploys secure, high-performance
remote access and virtual private network
solutions to allow clients, their employees,
supply-chain partners and other business partners
to access information remotely.
Advanced Technology Evaluation/Migration......... Helps clients choose the right technologies to meet
their business objectives and maximize their
competitive advantage in planning new network
services or upgrading existing ones. The services
include technology impact studies, technology
evaluation and testing, and failure and performance
analyses.
Wireless LAN Services........................... Assess, design and implement wireless LAN
architecture for corporate environments. The
services include requirements gathering, site
surveys, technology and product selection, wireless
LAN implementation, development of security policies
and architecture and integration of management
capabilities.
Network Design, Planning and Implementation...... Design and implement core backbones and campus
networks. The services include core optical backbone
design, campus network design, wireless network
design, IP addressing, DNS and DHCP design, protocol
transition services, project management and
implementation planning, staging/prototyping
services, and implementation team services.
Complex Network Troubleshooting.................. Address network performance and outage issues to get
the network running at optimum levels in the
shortest time possible.
6
Network and Systems Management. Our network and systems management
discipline combines proven methodologies, front-line strategies, and extensive
hands-on experience in advising world-class organizations how to architect and
implement enterprise management centers. The result is a system that delivers
the functionality, reliability, diagnostics and manageability essential to help
our clients' organizations meet their competitive challenges.
The following table lists some of the services provided by our network
and systems management discipline:
Service Description
------------------------------------------------- -------------------------------------------------
Enterprise Management Assessment................. Provides a comprehensive overview of a client's
enterprise management center with the goal of
consolidation, integration and simplicity of
operations. Develops recommendations to align the
enterprise management center with the needs of
the client's organization.
NOC "Pitstop"................................... Performs a diagnostic assessment of a client's
network management capabilities and existing Network
Operations Center. Provides a roadmap to achieving
business goals, as well as an actionable project
plan for improving performance metrics.
IT Management Center Engineering................. Assists clients in developing and deploying
enterprise management centers. Develops technical
specifications, working prototypes and then
implements the solution.
Event Correlation and Root Cause Analysis........ Provides methodology and tools for quickly and
efficiently pinpointing the location of the core
problems behind network faults so that they can
be resolved.
IT Service Definition/Measurement................ Establishes service definitions and instruments
for the measurement of service level agreements
within the enterprise structure.
Integrated Customer Service. Our integrated customer service discipline
helps organizations build proactive, customer-focused service centers that
handle all types of customer inquiries and drive service management. Our
solutions bring together a variety of management disciplines, including problem
management and asset management and service level management.
The following table lists some of the services provided by our
integrated customer service discipline:
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Service Description
------------------------------------------------- -------------------------------------------------
Call Center/Help Desk Assessment................. Assesses a clients' Call Center and/or IT Help
Desk. Identifies and prioritizes solutions that
will lower costs and enable clients to
effectively support technology.
Asset Management Assessment...................... Assess clients' asset management systems.
Analyzes current documentation and reports
and makes recommendations that enable clients to
effectively manage IT assets throughout the
lifecycle.
Rapid Analysis and Planning (RAP) Session........ 1-2 day working session with key personnel and
Predictive consultants to discuss issues and
develop solutions to specific infrastructure
management issues.
Asset Management Design and Implementation....... Design of an asset management solution that meets
client's business needs and facilitates the
management and inventory of IT assets. Includes
the implementation of that solution, and development
of a set of performance measurements to ensure that
solution continues to benefit the business.
Performance Management. Our performance management discipline leverages
proven methodologies and our extensive experience to help our clients optimize
their networks. We use sophisticated tools and techniques to gather, organize
and warehouse network performance data. This data may subsequently be used for a
number of related performance analysis applications, including capacity
planning, response time management and network simulation modeling. Consultants
in our performance management discipline are experts in applicable technologies,
including core competencies in remote monitoring, or RMON, data warehousing and
discrete event simulation modeling.
The following table lists some of the services provided by our
performance management discipline:
Service Description
------------------------------------------------- -------------------------------------------------
Network Baselining............................... Provides a snapshot of the current network
environment. The baseline can be used as a
comparison point as events change.
Capacity Planning................................ Projects network and system resource requirements
necessary to support business needs.
Application Impact Studies....................... Analyzes how an application uses network
resources to predict response times that users
will experience when the application is deployed
across the network. Recommends improvements that
enable the application to maximize network
resources.
Network Triage................................... Identifies root causes and provides resolution
for acute network performance problems.
Global Integrity Services. Our Global Integrity Services business unit
enables our clients to manage risk by understanding, prioritizing and mitigating
their security-related business risks with our comprehensive set of information
protection services. We help clients by assessing, designing, and implementing
secure revenue-enhancing electronic business solutions, cost saving networks,
wireless solutions and a variety of other services, all of which rely on a
secure infrastructure to save money or expand revenues.
8
The following table lists some of the services provided by our Global
Integrity Services business unit:
Service Description
------------------------------------------------- -------------------------------------------------
TrustCheck(TM) Assessment........................ Provides a consistent, quantitative measure of
information security for an organization, technical
infrastructure or application. Pinpoints
vulnerabilities and develops a specific ranking
that compares the client's security to its industry
peers.
Ethical Hacking.................................. Attacks a client's network infrastructure and
applications in order to determine how they might
be penetrated by a hacker.
Security Architecture Design and Implementation.. Design and implement secure networks, systems and applications
to be deployed throughout a client's infrastructure
using sophisticated technologies.
Application Security Assessment and Design....... Review the design and implementation of sensitive
applications to ensure that proper security controls
are included.
Incident Response and Digital Forensics.......... Development of a program and procedures for
responding and reacting to security incidents.
Includes training on evidence handling and forensic
analysis of data, development of procedures for
interacting with law enforcement and media, as well
as development of procedures for recovering systems
as quickly as possible. Services also include on-
site forensics support for Predictive clients.
GlobalSecure(TM) Management and Monitoring
Services......................................... Services include the remote monitoring and management
of firewalls and intrusion detection systems. Powered
by our partner, Riptech, these services provide 24x7
vigilance of a client's security systems to ensure
that attacks, incidents, and other security issues
are detected and acted upon as quickly as possible.
Security Intelligence Services................... A subscription service which provides clients with
information into the trends and evolution of the
threat. These services include distribution of daily
alerts regarding vulnerabilities in IT systems,
threats to physical security and high-level trends
in the threat model, pulled from various sources,
both public and private.
Clients
We have provided professional network and security services to a
variety of clients across a broad range of industries, including:
AIG Citigroup McDonald's
AT&T Devon Energy Pfizer
Bear Stearns Cox Communications Rabobank
BellSouth JPMorgan Chase Time
Cable & Wireless Maher Terminals Verizon
Sales and Marketing
We have developed direct and indirect sales channels for the sale of
our services. To facilitate our direct sales effort we have developed the
infrastructure necessary to capture and track the major sales indicators through
the sales cycle. Additionally, a significant amount of time and effort has been
and will continue to be invested in the development of tools, training materials
and training for sales and technical personnel. We have developed a number of
strategic relationships, including alliances with Cisco Systems, InfoVista ,
Micromuse, SMARTS and Symantec. Under these relationships, our partners
recommend or directly resell our services to their clients, including our
consulting services on a project outsource basis. We intend to continue to
expand the scope of these relationships and to develop new strategic alliances
to further broaden the indirect sales channel for our services.
9
Human Resources
We seek to attract, train, retain and deliver the highest level of
technical talent. We believe that our proactive approach gives us a strong
competitive edge in the marketplace and a scalable, consistently high standard
of service delivery. As of March 15, 2003, we had 200 full-time employees.
Competition
The network infrastructure and security consulting industry is
comprised of many participants, is highly competitive and is subject to rapid
technological change. We face intense competition from systems integrators,
value added resellers, network services firms, security consulting firms,
telecommunications providers, network equipment and computer systems vendors.
Many of our competitors have greater name recognition, longer operating
histories, more relationships with large and established clients and greater
financial, technical and managerial resources. Furthermore, we expect that our
competitors may in the future form alliances with other technology vendors,
which may give them an advantage in managing networks that use that vendor's
equipment.
Most of our current clients and prospective clients have internal
information technology departments and could choose to satisfy their network
management needs through internal resources rather than by outsourcing them to
third-party service providers such as ourselves. The decision by clients or
prospective clients to rely on their own information technology departments
could have a material adverse affect on our business, results of operations and
financial condition. Moreover, as the domestic and global markets for
information technology services continue to grow, we expect to face stiff
competition from new entrants into the network management consulting industry.
We believe that the principal competitive factors in the network
infrastructure and security consulting market are the ability to attract and
retain qualified personnel, quality and breadth of services offered, price and
reliability of services provided and the strength of client relationships. We
believe we compete favorably with respect to all of these factors. We believe we
distinguish ourselves from our competitors through our expertise in managing
complex, multi-vendor networks and our ability to provide clients with cost
certainty and guaranteed deliverables.
Intellectual Property and Proprietary Rights
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. Despite our precautions, it may be possible
for third parties to obtain and use our intellectual property without our
authorization. Furthermore, the validity, enforceability and scope of protection
of intellectual property in Internet-related industries is still evolving. The
laws of some foreign countries do not protect intellectual property to the same
extent as do the laws of the United States.
We pursue the registration of our trademarks in the United States and
England. We may not be able to secure adequate protection of our trademarks in
the United States and other countries. Effective trademark protection may not be
available in all the countries in which we conduct business. Policing
unauthorized use of our marks is also difficult and expensive. In addition, it
is possible that our competitors have adopted or will adopt product or service
names similar to ours, thereby impeding our ability to build brand identity and
possibly leading to customer confusion.
We cannot be certain that our services and the finished products that
we deliver do not or will not infringe valid patents, copyrights, trademarks or
other intellectual property rights held by third parties. 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 or may materially disrupt the conduct of our
business.
International Operations
We currently have offices in the United Kingdom and the Netherlands. The
scope of our international operations includes service delivery and sales and
marketing. Geographic revenue classification is based on the country in which
the sale is invoiced. Revenue for the fiscal year ended December 31, 2002 was
82% North America and 18% international, 89% North America and 11% international
for the comparable period in 2001 and 91% North America and 9% international for
the comparable period in 2000.
10
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 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 business, financial condition and operating results will
continue to suffer.
We have lost money from operations in the past and expect to incur additional
losses for the foreseeable future, which could impact our stock price and
liquidity.
Our net loss for the 12 months ended December 31, 2002 was $61.9
million. As of December 31, 2002, our accumulated deficit was $206.3 million. We
expect to generate significant net losses for the foreseeable future and may
never achieve profitability. If we do not achieve profitability, our stock price
may decline. In addition, 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.
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 year ended December 31, 2002, BellSouth and Pfizer accounted
for approximately 15.0% and 13.7%, respectively of revenues before reimbursed
expenses. Our five largest clients accounted for approximately 45.4% of revenues
before reimbursed expenses for the year ended December 31, 2002. For the year
ended December 31, 2001, our five largest clients accounted for approximately
40.6% of our revenues before reimbursed expenses. 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 December 31, 2002, the accounts
receivable from BellSouth and Pfizer were approximately $524,977 and $341,832,
respectively, which related to work performed in October through December 2002.
We believe that we will continue to depend on a small number of large customers
for a significant portion of our revenues.
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.
11
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 our own expectations or 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 years ended December 31, 2002 and 2001, fixed-price projects
accounted for 37.0% and 48.2% of revenues before reimbursed expenses,
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 an 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.
12
Risks Related to Our Strategy and Market
We may have difficulty managing the fluctuations in the demand for our services,
which could have adverse effects on our business
Our business has recently experienced lower revenues due to decreased
customer demand for our services. Since December 31, 2000, to scale back our
operations and to reduce our expenses in response to this reduced demand for our
services, we have decreased our headcount to 236 employees as of December 31,
2002 from approximately 691 employees as of December 31, 2000. While this action
has 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. A key part of our strategy going forward is to grow our business.
In order to achieve this growth, demand for our services must increase. If the
opportunity to grow our business arises, we may need to modify our financial and
management controls, reporting systems and procedures and to train our work
force. We may not be able to do so successfully, causing 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 Chief Financial Officer in August 2002 and
Shawn Kreloff was appointed our Executive Vice President of Sales and Business
Development in September 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 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.
13
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. We may experience difficulties or delays in
our development efforts with respect to new services or enhancements, and may
not ultimately be successful in developing them. Any significant delay in
releasing new services or enhancements could adversely affect our reputation,
give a competitor a first-to-market or cause a competitor to achieve greater
market share.
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 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
We operate internationally in The United Kingdom and The Netherlands.
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;
14
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 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.
The war with Iraq and continued threats of terrorism may harm our business and
negatively impact the U.S. and global economy.
The economic uncertainty resulting from the unpredictability of
military action and other responses associated with the war with Iraq may
negatively impact consumer as well as business confidence in the near term. In
addition, the continued threat of terrorism and heightened security measures in
response to this threat have caused and may continue to cause significant
disruptions to commerce throughout the world. To the extent that this economic
uncertainty and these continued disruptions result in a general decrease in
corporate spending on information technology, our business, revenues and results
of operations could be harmed. We are unable to predict whether the war with
Iraq, threats of terrorism or the response thereto will result in any long-term
commercial disruptions or if such activities or responses will have a long-term
adverse effect on our business, strategy, results of operations or financial
condition.
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 protracted and costly 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. We may also be required to
obtain a license from a third party or cease activities utilizing a third
party's proprietary rights.
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.
15
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.
Due to the fact that our stock price had not met the $1.00 minimum price
requirement of the Nasdaq National Market, our common stock is no longer listed
on the Nasdaq National Market, which may adversely impact the liquidity of your
shares.
Our common stock is currently listed on the Nasdaq SmallCap Market. The
trading volume of our common stock listed on the Nasdaq SmallCap Market has been
significantly less than the historical volume when our common stock was listed
on the Nasdaq National Market, and accordingly, there may not be significant
liquidity if and when you desire to sell your shares. This lack of liquidity may
result in holders not being able to purchase or sell shares as quickly and
inexpensively as they have done historically, and may impact the trading price
of our common stock.
The Nasdaq SmallCap Market also maintains a $1.00 minimum price
requirement. On March 27, 2003, the price of our common stock was $0.28. We have
until July 21, 2003 to regain compliance with the minimum bid requirement,
subject to possible extension if we meet certain requirements to extend such
compliance period. There is no assurance we will meet the required criteria, or
that this compliance period will be extended in the event we do not. If we are
delisted from the Nasdaq SmallCap Market, 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, and our ability to raise financing will be materially and adversely
affected.
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 28.9% 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.
Available Information
Our reports filed with Securities and Exchange Commission, including
our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports
on Form 8-K and amendments to reports filed pursuant to Sections 13(a) and 15(d)
of the Securities Exchange Act of 1934, as amended, are available on our website
at http://www.predictive.com, when such reports are available on the Securities
and Exchange Commission website.
Item 2. Properties
Our principal executive offices are located in New York, New York. We
also lease office space in California, Georgia, Minnesota, New Jersey, Virginia,
England and The Netherlands.
We believe that our existing facilities are adequate for our current
needs and that additional space will be available as needed.
16
Item 3. Legal Proceedings
Except as set forth below, we are not a party to any material legal
proceedings.
Certain investment bank underwriters, and certain of our directors and
officers have been named in a putative class action for violation of the federal
securities laws in the United States District Court for the Southern District of
New York, captioned In Predictive Systems, Inc. Initial Public Offering
Securities Litigation, 01 Civ. 10059 (SAS). This is one of a number of cases
challenging underwriting practices in the initial public offerings ("IPOs") of
more than 300 companies. These cases have been coordinated for pretrial
proceedings as In re Initial Public Offering Securities Litigation, 21 MC 92
(SAS). Plaintiffs generally allege that certain underwriters engaged in
undisclosed and improper underwriting activities, namely the receipt of
excessive brokerage commissions and customer agreements regarding post-offering
purchases of stock in exchange for allocations of IPO shares. Plaintiffs also
allege that various investment bank securities analysts issued false and
misleading analyst reports. The complaint against the Company claims that the
purported improper underwriting activities were not disclosed in the
registration statements for our IPO and Secondary Offering and seeks unspecified
damages on behalf of a purported class of persons who purchased the Company's
securities or sold put options during the time period from October 27, 1999 to
December 6, 2000. On February 19, 2003, the Court issued an Opinion and Order
denying our motion to dismiss certain of the claims in the complaint. We believe
we have meritorious defenses against the allegations in the complaint and intend
to defend the case vigorously.
On or about November 13, 2002, ICG Communications filed a claim against
the Company in the Federal Bankruptcy Court alleging that approximately $4.3
million in payments that the Company received from ICG within the 90 days
preceding ICG's bankruptcy filing were voidable as preferential transfers under
section 547 of the United States Bankruptcy Code. On March 27, 2003 the Company
and ICG reached an agreement to settle this claim for $350,000. This agreement
is subject to bankruptcy court approval.
In February 28, 2003, Brian Mulvey, a former employee of the Company,
and his wife Nancy Mulvey, filed a lawsuit in the Superior Court of New Jersey
against the Company and four of our managers. The Mulveys have alleged that
during Brian Mulvey's employment with the Company, he was subjected to age
discrimination, sexual harassment and other such conduct. Nancy Mulvey is
Brian's Mulvey's wife, but was never employed with the Company. Plaintiffs seek
an unspecified amount of compensatory damages, emotional distress damages,
punitive damages, attorneys' fees and costs. We deny the allegations of the
complaint and plan to vigorously defend the case.
Item 4. Submission of Matters to a Vote of Security Holders
We held our 2002 Annual Meeting of Stockholders on December 10, 2002. At that
meeting, the stockholders approved the following proposals: (i) the election of
Inder Sidhu and William L. Smith as Class III directors to serve on the Board of
Directors until the 2005 Annual Meeting of Stockholders, (ii) the amendment of
our 1999 Stock Incentive Plan to (a) increase the maximum number of options or
shares that may be granted to one person in any calendar year to 2,000,000 from
500,000; and (b) increase the number of options issued to non-employee Board
members upon their initial appointment to the Board and upon the date of each
Annual Meeting of Stockholders to 75,000 and 10,000 shares, respectively, from
25,000 and 2,500 shares, respectively, (iii) the amendment of our 1999 Employee
Stock Purchase Plan to increase the number of shares of our common stock that
may be issued thereunder from 750,000 shares up to a maximum of 1,150,000
shares, and (iv) the ratification of the Board of Directors' decision to select
Deloitte & Touche LLP as our independent public accountants for the year ending
December 31, 2002.
There were 31,129,857 votes cast for, 557,654 votes cast against and 0
abstentions in connection with the election of Inder Sidhu as a Class III
Director. There were 29,950,795 votes cast for, 1,736,716 votes cast against and
0 abstentions in connection with the election of William L. Smith as a Class III
Director.. There were 27,572,086 votes cast for, 4,111,980 votes cast against
and 3,445 abstentions in connection with the approval of an amendment to our
1999 Stock Incentive Plan to (a) increase the maximum number of options or
shares that may be granted to one person in any calendar year to 2,000,000 from
500,000; and (b) increase the number of options issued to non-employee Board
members upon their initial appointment to the Board and upon the date of each
Annual Meeting of Stockholders to 75,000 and 10,000 shares, respectively, from
25,000 and 2,500 shares, respectively. There were 30,017,428 votes cast for,
1,667,313 votes cast against and 2,770 abstentions in connection with the
approval of an amendment to our 1999 Employee Stock Purchase Plan to increase
the number of shares of common stock that may be issued thereunder from 750,000
shares up to a maximum of 1,150,000 shares. There were 31,659,515 votes cast
for, 21,701 votes cast against and 6,295 abstentions in connection with
ratification of the Board of Director's decision to select Deloitte & Touche LLP
as our independent public accountants for the year ending December 31, 2002.
17
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Market Information
Our common stock has been quoted on the Nasdaq SmallCap Market under
the symbol PRDS since December 13, 2002 and on the Nasdaq National Market under
the symbol PRDS from our initial public offering on October 27, 1999 to December
12, 2002. The following table sets forth, for the period indicated, the high and
low sale prices per share of the common stock as reported on the Nasdaq National
Market and Nasdaq SmallCap Market.
High Low
----- -----
First Quarter 2001 ................................. 9.19 2.00
Second Quarter 2001 ................................. 5.40 1.19
Third Quarter 2001 ................................. 4.00 0.70
Fourth Quarter 2001 ................................. 2.08 0.70
First Quarter 2002 ................................. 2.58 1.25
Second Quarter 2002 ................................. 1.55 0.31
Third Quarter 2002 ................................. 0.37 0.13
Fourth Quarter 2002 ................................. 0.56 0.18
On March 27 , 2003, the last sale price of our common stock reported on
the Nasdaq SmallCap Market was $0.28 per share.
The Company maintains the 1999 Stock Incentive Plan (the "1999 Plan"), and the
1999 Employee Stock Purchase Plan (the "Purchase Plan"), pursuant to which it
may grant equity awards to eligible persons. The following table sets forth
information about equity awards under the Company's plans as of the close of the
fiscal year ended December 31, 2002.
(a) (b) (c)
Number of
Securities to be Weighted- Number of Securities
Issued upon Average Exercise Remaining Available for
Exercise of Price of Future Issuance under
Outstanding Outstanding Equity Compensation
Options, Options, Plans (Excluding
Warrants and Warrants and Securities
Plan Category Rights Rights Reflected in Column (a))
------------------------------------------- ------ ------ ------------------------
Equity compensation plans approved
by security holders..................... 7,715,836 $0.89 13,140,506 (1)/(2)
Equity compensation plans not
approved by security holders (3)........ 1,298,730 $0.33 0
Total.............................
(1) The 1999 Plan incorporates an evergreen formula pursuant to which on each
January 1, the aggregate number of shares reserved for issuance under the
1999 Plan will increase by a number of shares equal to 1% of the
outstanding shares on the day preceding (December 31), but no such annual
increase will exceed 500,000 shares.
(2) Of these shares, 698,535 shares remain available for purchase under the
Purchase Plan.
(3) There remained outstanding as of December 31, 2002 59,959 stock options
under the 1996 Synet Stock Option Plan and 2,625 stock options under the
Global Integrity 1998 Stock Incentive Plan with a weighted average exercise
price of $2.70 and $7.62 per share, respectively. The Company assumed the
options under these plans in connection with its acquisition of Synet
Service Corporation and Global Integrity Corporation, respectively, in the
fourth quarter of 2000. No further awards will be made under either option
plan. Statistics regarding these plans are not included in the above table.
Holders
As of March 27, 2003, we had approximately 136 holders of record of our
common stock.
18
Dividends
We have never declared or paid any cash dividends on our common stock.
We currently intend to retain future earnings, if any, to finance the expansion
of our business. As a result, we do not intend to pay cash dividends in the
foreseeable future.
Recent Sales of Unregistered Securities
On September 19, 2002, we sold 238,095 shares of our common stock to
Shawn Kreloff, one of our officers, at a price of $0.21 per share for total
proceeds of $49,999.95 in reliance upon the exemption from registration provided
by Section 4(2) of the Securities Act.
19
Item 6. Selected Consolidated Financial Data
The selected consolidated balance sheet data as of December 31, 2002
and 2001 and the selected consolidated statements of operations data for the
years ended December 31, 2002, 2001 and 2000 have been derived from our audited
consolidated financial statements included elsewhere in this annual report. The
selected consolidated balance sheet data as of December 31, 2000, 1999 and 1998
and the selected consolidated statements of operations data for the years ended
December 31, 1999 and 1998 have been derived from our consolidated audited
financial statements not included in this annual report.
The selected consolidated financial data set forth below should be read
in conjunction with Management's Discussion and Analysis of Financial Condition
and Results of Operations and the consolidated financial statements and the
notes to those statements included elsewhere in this annual report.
Year Ended December 31,
--------------------------------------------------
2002 2001 2000 1999 1998
-------- ------- ------- ------- -------
(in thousands, except per share data)
Statement of Operations Data:
Revenues:
Professional services ......................................... $ 44,891 $ 66,217 $ 85,325 $ 50,698 $ 23,858
Reimbursed expenses ........................................... 1,253 1,872 2,921 1,054 398
Hardware and software sales ................................... 3,816 1,991 2,950 2,047 2,065
-------- ------- ------- ------- -------
Total revenues ............................................. 49,960 70,080 91,196 53,799 26,321
Cost of Revenues:
Professional services ......................................... 31,685 50,518 47,420 25,699 12,861
Reimbursed expenses............................................ 1,253 1,872 2,921 1,054 398
Hardware and software.......................................... 3,419 2,090 2,201 1,766 1,699
-------- ------- ------- ------- -------
Total cost of revenues ..................................... 36,357 54,480 52,542 28,519 14,958
-------- ------- ------- ------- -------
Gross profit ................................................... 13,603 15,600 38,654 25,280 11,363
Operating Expenses:
Sales and marketing ........................................... 8,027 15,830 12,290 8,478 3,433
General and administrative .................................... 20,372 42,058 32,231 16,809 8,184
Depreciation and amortization ................................. 1,708 2,873 1,657 756 568
Intangibles amortization ...................................... 1,961 21,933 2,912 327 --
Loss on equipment.............................................. -- 443 -- -- --
Impairment of goodwill and intangibles......................... 9,305 60,485 -- -- --
Impairment of property and equipment........................... 4,510 -- -- -- --
Restructuring and other charges................................ 7,468 14,672 -- -- --
Loss on long-term investments in related parties............... -- 2,000 -- -- --
Noncash charges for stock-based compensation and services...... 329 276 158 48 --
-------- ------- ------- ------- -------
Operating loss ................................................. (40,077) (144,970) (10,594) (1,138) (822)
Other income(expense):
Interest income ............................................... 411 2,565 7,261 944 58
Other income (expense) ........................................ 1,123 (51) (268) 76 1
Interest expense .............................................. (35) (52) (191) (157) (324)
-------- ------- ------- ------- -------
Loss before income tax provision (benefit) and cumulative
effect of change in accounting principle....................... (38,578) (142,508) (3,792) (275) (1,087)
Income tax provision (benefit) ................................. 40 (1,635) 95 682 (460)
-------- ------- ------- ------- -------
Loss before cumulative effect of change in accounting principle. (38,618) (140,873) (3,887) (957) (627)
Cumulative effect of change in accounting principle............. (23,308) -- -- -- --
-------- ------- ------- ------- -------
Net loss........................................................ $(61,926) $(140,873) $ (3,887) $ (957) $ (627)
======== ======= ======= ======= =======
Basic and diluted loss per common share before cumulative
effect of change in accounting principle....................... $ (1.03) $ (3.91) $ (0.15) $ (0.08) $ (0.11)
Cumulative effect of change in accounting principle............. (0.63) -- -- -- --
-------- ------- ------- ------- -------
Basic and diluted net loss per common share..................... $ (1.66) $ (3.91) $ (0.15) $ (0.08) $ (0.11)
======== ======= ======= ======= =======
Basic and diluted weighted average common shares outstanding.... 37,331 36,008 26,274 12,138 6,015
======== ======= ======= ======= =======
20
See Note 4 to our consolidated financial statements for an explanation
of the number of shares used in per share computations.
December 31,
-------------------------------------------------
2002 2001 2000 1999 1998
-------- -------- ------- ------ ------
(in thousands)
Balance Sheet Data:
Cash and cash equivalents ........................ $ 19,465 $ 41,278 $ 80,059 $ 89,634 $ --
Marketable securities ............................ -- -- 3,794 2,018 --
Working capital .................................. 21,675 41,262 99,631 102,092 2,365
Total assets ..................................... 32,210 102,493 246,329 117,250 13,677
Total stockholders' equity ....................... 24,466 84,937 223,694 108,502 2,026
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
The following discussion of our financial condition and results of
operations should be read in conjunction with our consolidated financial
statements and related notes thereto included elsewhere in this Annual Report on
Form 10-K. This discussion contains forward-looking statements, which involve
risks and uncertainties. Our actual results could differ materially from those
anticipated in these forward-looking statements for many reasons, including the
risks described in "Risk Factors" starting on page 11 and elsewhere in this
Annual Report.
Overview
The principal source of our revenues is fees 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 hours 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 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 under utilization 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 under
utilization include:
o the reduction in size, delay in commencement, interruption or
termination of one or more significant projects;
o the completion during a quarter of one or more significant
projects;
o the miscalculation of resources required to complete new or
ongoing projects; and
o the timing and extent of training, weather related shut-downs,
vacations and holidays.
Our cost of revenues consists 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 that are not reimbursed by our clients. Costs of
hardware and software purchases consist of acquisition costs of third-party
hardware and software that is resold.
21
Given 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.
On August 12, 1999, we acquired Network Resource Consultants and
Company B.V. ("NRCC") for an aggregate purchase price of approximately $4.3
million. The purchase price was paid in the form of 1,062,814 shares of our
common stock in exchange for all of the outstanding capital stock of NRCC. The
acquisition was accounted for as a purchase and resulted in intangible assets of
approximately $4.3 million representing the excess purchase price over the fair
value of the net tangible assets acquired. Subsequent to the acquisition and
until the adoption of SFAS 142 on January 1, 2002, goodwill was being amortized
on a straight-line basis over a period of five years. In December 2002, our
subsidiary in Germany, which is included in our International Consulting
reporting unit, filed for bankruptcy. The provisions of SFAS 142 required that
we review goodwill associated with our International Consulting reporting unit
as a result of the bankruptcy filing. Based on the analysis of goodwill
associated with the International Consulting reporting unit it was determined
that impairment existed at December 31, 2002. As a result we have reduced
goodwill for our International Reporting Unit which was recorded in connection
with the acquisition of NRCC by approximately $561,000 for the year ended
December 31, 2002.
On September 16, 1999, we completed the sale of 1,242,000 shares of our
common stock to Cisco at $12.00 per share for net proceeds of approximately
$14.2 million.
On September 22, 1999, we completed the sale of 94,867 and 18,133
shares of our common stock to General Atlantic Partners 57, L.P., and GAP
Coinvestment Partners II, L.P., respectively, at $12.00 per share for net
proceeds of approximately $1.4 million.
On November 1, 1999, we consummated the initial public offering of 4.6
million shares of our common stock, at $18.00 per share, which resulted in net
proceeds to us of approximately $75.1 million after deducting underwriter
discounts and commissions, and other expenses paid by us.
On April 5, 2000, we consummated a follow-on public offering for 3.8
million shares of our common stock at $43.00 per share, of which 1.0 million
shares were sold by us, while the reminder were sold by our stockholders,
resulting in net proceeds to us of approximately $39.8 million after deducting
underwriter discounts and commissions, and other expenses paid by us.
On October 16, 2000, we acquired Synet Service Corporation ("Synet")
for an aggregate purchase price, valued at the time of the transaction, of
approximately $33.4 million. The purchase price was paid in the form of
1,922,377 shares of our common stock, options to purchase 242,459 shares of our
common stock and $9.0 million in cash, including certain transaction expenses,
in exchange for all of the outstanding capital stock of Synet. The acquisition
was accounted for as a purchase and resulted in intangible assets of
approximately $33.4 million representing customer lists, workforce and the
excess of the purchase price over the fair value of the net tangible assets
acquired. During 2001, we adjusted the purchase price by $23,000 for the closing
of certain offices and a reduction in workforce in connection with the
acquisition plan and to adjust the final purchase price allocation. In the third
quarter of fiscal 2001, we reviewed goodwill and the intangible assets for
impairment due to revenue declines in this business in relation to prior periods
and forecasted earnings and to the overall deterioration of market conditions in
the enterprise sector. As a result of this review, an impairment loss of $18.2
million was recognized for the difference between the estimated value of Synet
based on future discounted cash flows and the carrying amount of its assets and
liabilities, including goodwill. Subsequent to the acquisition and until the
adoption of Statement of Financial Accounting Standards No. 142, "Goodwill and
Intangible Assets," (SFAS 142) on January 1, 2002, goodwill and the intangible
assets were being amortized on a straight-line basis over periods of three to
five years. Upon adoption of SFAS 142, we evaluated goodwill for impairment and
determined that impairment existed as of January 1, 2002. Of the impairment
charge recorded, approximately $7.0 million pertained to goodwill associated
with the acquisition of Synet. Such impairment charge is included in the
cumulative effect of change in accounting principle. Given the continuing
decline in our revenues and market capitalization and the overall deterioration
of market conditions in the enterprise sector, we also reviewed our long-lived
assets for impairment during 2002 in accordance with the provisions of Statement
of Financial Accounting Standards No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets" (SFAS 144). Based on this review, we recognized
an impairment charge to reduce the carrying value of our finite lived intangible
assets, of which approximately $517,000 pertained to intangibles recorded in
connection with the acquisition of Synet.
22
On December 14, 2000, we acquired Global Integrity Corporation ("Global
Integrity") for an aggregate purchase price, valued at the time of the
transaction, of approximately $78.3 million. The purchase price was paid in the
form of 5,240,275 shares of our common stock, options to purchase 551,048 shares
of common stock and $31.5 million in cash, including certain transaction
expenses in exchange for all of the outstanding capital stock of Global
Integrity. The acquisition was accounted for as a purchase and resulted in
intangible assets of approximately $81.1 million representing customer lists,
workforce, trade names, developed technology and the excess of the purchase
price over the fair value of the net tangible assets acquired. During 2001, we
adjusted the purchase price by $3.3 million for the closing of certain offices
and a reduction in workforce in connection with the acquisition plan and to
adjust the final purchase price allocation. In the third quarter of fiscal 2001,
we reviewed goodwill and the intangible assets for impairment due to revenue
declines in this business in relation to prior periods and forecasted earnings
and to the overall deterioration of market conditions in the enterprise sector.
As a result of this review, an impairment loss of $42.3 million was recognized
for the difference between the estimated value of Global Integrity based on
future discounted cash flows and the carrying amount of its assets and
liabilities, including goodwill. Subsequent to the acquisition and until the
adoption of SFAS 142 on January 1, 2002, goodwill and the intangible assets were
being amortized on a straight-line basis over periods of three to five years.
Upon adoption of SFAS 142, we evaluated goodwill and our tradename intangible
for impairment and determined that impairment existed as of January 1, 2002. Of
the impairment charge recorded, approximately $16.3 million pertained to
goodwill and tradenames associated with the acquisition of Global Integrity.
Such impairment charge is included in the cumulative effect of change in
accounting principle. Given the continuing decline in our revenues and market
capitalization and the overall deterioration of market conditions in the
enterprise sector, we also reviewed our long-lived assets for impairment during
2002 in accordance with the provisions of SFAS 144. Based on this review, we
recognized an impairment charge to reduce the carrying value of our finite lived
intangible assets, of which approximately $8.2 million pertained to intangibles
recorded in connection with the acquisition of Global Integrity.
In February 2001, our management foresaw the need to lower the
operating costs of the business given its near-term revenue projections.
Therefore, we established a plan that included the following: (1) a reduction in
our 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.
For the year ended December 31, 2001, we recorded restructuring charges
of $9.3 million in connection with our 2001 restructuring plan. Such charges
consisted of $3.4 million in severance benefits and other related expenses for a
reduction in headcount of 251 employees and $5.9 million in exit costs related
to real estate and electronic equipment.
In December 2001, we formed a strategic alliance with an unaffiliated
third party (the "Alliance Partner") to outsource the monitoring services
provided by our Managed Security Services division. As a result of this
alliance, we established a restructuring plan that included the following: (1) a
reduction of our workforce; (2) the write-off of equipment and software
development costs associated with our security operations center which was no
longer needed as a result of the outsourcing; and (3) non-recoverable costs
incurred to convert clients to the Alliance Partner.
For the year ended December 31, 2001, we reduced headcount by 12
employees and recorded restructuring charges of $4.4 million in connection with
the outsourcing of our monitoring services. Such charges consisted of $315,000
in severance benefits, $798,000 in non-recoverable costs to convert clients to
the Alliance Partner and other related charges, and $3.3 million for the
write-off of equipment and software development costs associated with our
security operations center, which was no longer needed as a result of the
outsourcing.
In 2002, we reversed $433,000 of the restructuring charges previously
accrued in 2001 in connection with the outsourcing of our monitoring services.
Of this amount, $150,000 was received from the sale of equipment previously
written-off and an additional $283,000 was reversed for accruals, which were no
longer considered necessary.
In January 2002, our management foresaw the need to continue to lower
the operating costs of the business given continuing difficult market
conditions. Therefore, we established a 2002 restructuring plan that included
the following: (1) a reduction in our 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 year ended December 31, 2002, we recorded restructuring charges
of $5.9 million in connection with our 2002 restructuring plan. Such charges
consisted of $3.3 million in severance benefits and other related expenses for a
reduction in headcount of 156 employees, $2.3 million in exit costs related to
real estate and electronic equipment leases for the closing of domestic offices,
and an increase to previously accrued exit costs in the amount of $181,000
resulting from favorable and unfavorable settlements and changes to subtenant
assumptions for leased domestic offices.
In December 2002, our subsidiary in Germany, Predictive AG, filed for
bankruptcy resulting in the termination of the German operations. As a result,
we recorded a restructuring charge equal to the net assets of Predictive AG in
the amount of $284,000 and recorded an additional $25,000 in legal costs
associated with the bankruptcy.
23
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 this Annual Report on Form 10-K. 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 or estimates utilized by management.
We recognize revenue for fixed price contracts in accordance with AICPA
Statement of Position 81-1, "Accounting for Performance of Construction Type and
Certain Production Type Contracts." 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 direct labor 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. Periodically we may encounter changes in
the number of hours or other costs estimated to complete a project. When such
circumstances occur, we make adjustments to the cost and profitability estimates
for the contract in the period in which the changes become known. If such
revisions indicate a loss will be incurred on the contract, we record the entire
loss at such time. Under each arrangement, revenues are recognized when an
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 our tradename intangible.
The carrying value of goodwill and indefinite lived intangibles are evaluated
for impairment on an annual basis. We also review goodwill and indefinite lived
intangibles for impairment whenever events or changes in circumstances indicate
that their carrying amount may be impaired. If the carrying value of goodwill
exceeds its implied value an impairment loss is recognized for an amount equal
to the excess of the carrying value over the implied value. If the carrying
amount of an indefinite lived intangible asset exceeds its fair value, an
impairment loss shall be recognized in an amount equal to that excess. Our
reporting units utilized for evaluating the recoverability of goodwill and the
indefinite lived intangibles are the same as our operating segments. Upon
adoption of Statement of Financial Accounting Standards No. 142, "Goodwill and
Other Intangible Assets" (SFAS 142), we evaluated goodwill and our tradename
intangible for impairment as required by that statement and determined that an
impairment of $23.3 million existed at January 1, 2002. This impairment has been
recorded in the financial statements as a cumulative effect of a change in
accounting principle. An independent third party valuation specialist using a
combination income and market approach determined the estimated fair value of
our reporting units and our tradename intangible at January 1, 2002. In December
2002, our German subsidiary, which is included in our International Consulting
reporting unit, filed for bankruptcy. The provisions of SFAS 142 required that
we review goodwill associated with our International Consulting reporting unit
for impairment as a result of the bankruptcy filing. Based on this review by an
independent third party valuation specialist using a combined income and market
approach it was determined that an impairment of $561,000 existed at December
31, 2002 related to the goodwill of the International Consulting reporting unit.
Long-Lived Assets: Long-lived assets, including finite lived intangible
assets, are reviewed for impairment whenever events or changes in circumstances
indicate that the carrying amount of the asset or asset group may not be
recoverable. An impairment loss is recognized if the carrying amount of a
long-lived asset group is not recoverable. 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 loss 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 finite lived
intangible assets and other long-lived assets for the US Consulting and Managed
Security Services reporting units, it was determined that the carrying values of
these assets were not recoverable. As a result, we recorded an impairment charge
during 2002 related to finite lived intangibles and property and equipment of
$8.7 million and $4.5 million, respectively. The fair values of the asset groups
were determined based on the discounted cash flows expected to be generated from
such asset groups over the estimated remaining useful life of the principle
asset in each group.
24
Stock-Based Compensation: In October 2002, we adopted the fair value
provisions of Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation" (SFAS 123). Prior to the adoption of SFAS 123, we
accounted for our stock-based compensation arrangements with our employees using
the intrinsic value method in accordance with the provisions of Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB
25), and complied with the disclosure provisions of SFAS 123. SFAS 123
established a fair-value-based method of accounting for stock-based compensation
plans. Pursuant to the transition provisions of SFAS 123, we are required to
apply the fair value method of accounting to all option grants issued or
modified on or after January 1, 2002. The fair value method will not be applied
to stock option awards granted in fiscal years prior to 2002. Such awards will
continue to be accounted for under the intrinsic value method pursuant to APB
25, except to the extent that prior years' awards are modified subsequent to
January 1, 2002. As a result of adoption of SFAS 123, we recorded an additional
charge to noncash charges for stock based compensation and services of
approximately $210,000 for the year ended December 31, 2002. The Black-Scholes
option-pricing model was used to determine the estimated fair value of stock
options issued and modified during 2002. The use of this model required
management to make certain estimates for values of variables used by the model.
Management estimated the values for stock price volatility, the expected life of
the equity instruments and the risk free rate based on information that was
available to management at the time the Black-Scholes option-pricing
calculations were performed.
Income Taxes: Operating losses in prior periods have generated
significant state and federal tax net operating losses, or NOL carryforwards.
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 and our
expected losses for the foreseeable future, 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 would 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
The following table sets forth certain financial data for the periods
indicated expressed as a percentage of total revenues:
December 31,
--------------------------------
2002 2001 2000
-------- -------- ---------
Revenues:
Professional services ............................................... 89.9% 94.5% 93.6%
Reimbursed expenses.................................................. 2.5 2.7 3.2
Hardware and software sales ......................................... 7.6 2.8 3.2
------- ------- -------
Total revenues..................................................... 100.0 100.0 100.0
Cost of Revenues:
Professional services ............................................... 63.4 72.0 52.0
Reimbursed expenses.................................................. 2.5 2.7 3.2
Hardware and software .............................................. 6.9 3.0 2.4
------- ------- -------
Total cost of revenues............................................. 72.8 77.7 57.6
------- ------- -------
Gross profit.......................................................... 27.2 22.3 42.4
Operating Expenses:
Selling and marketing ............................................... 16.0 22.6 13.5
General and administrative .......................................... 40.8 60.0 35.4
Depreciation and amortization ....................................... 3.4 4.1 1.8
Intangibles amortization ............................................ 3.9 31.3 3.2
Loss on equipment.................................................... -- 0.6 --
Impairment of goodwill and intangibles............................... 18.6 86.3 --
Impairment of property and equipment................................. 9.0 -- --
Restructuring and other charges...................................... 14.9 20.9 --
Loss on long-term investments in related parties..................... -- 2.9 --
Noncash charges for stock-based compensation and services ........... 0.7 0.4 0.2
------- ------- -------
Operating loss........................................................ (80.1) (206.8) (11.7)
Other income (expense), net........................................... 2.2 (0.1) (0.3)
Interest income, net.................................................. 0.8 3.6 7.8
------- ------- -------
Loss before income tax provision (benefit) and cumulative
effect of change in accounting principle............................. (77.1) (203.3) (4.2)
Income tax provision (benefit) ....................................... 0.1 (2.3) 0.1
------- ------- -------
Loss before cumulative effect of change in accounting principle....... (77.2) (201.0) (4.3)
Cumulative effect of change in accounting principle................... (46.7) -- --
------- ------- -------
Net loss.............................................................. (123.9)% (201.0)% (4.3)%
======= ======= =======
25
Years Ended December 31, 2002 and 2001
Revenues. Our principal source of revenues is fees from professional
services. Total revenues decreased 28.7% to $50.0 million for the year ended
December 31, 2002 from $70.1 million for the year ended December 31, 2001.
Revenues from professional services decreased 32.2% to $44.9 million for the
year ended December 31, 2002 from $66.2 million for the year ended December 31,
2001. This decrease was primarily due to difficult market conditions affecting
the technology industry in general and the telecommunications and enterprise
sector in particular. These sectors are experiencing a drastic downturn and that
downturn has adversely impacted our ability to secure new business. Reimbursed
expenses decreased 33.1% to $1.3 million for the year ended December 31, 2002
from $1.9 million for the year ended December 31, 2001. This decrease was
primarily attributable to the nature of the customer contracts in addition to
the overall decline in professional services revenues. Revenues from hardware
and software sales increased 91.7% to $3.8 million for the year ended December
31, 2002 from $2.0 million for the year ended December 31, 2001. This increase
was primarily due to one contract where the client requested us to supply all
hardware and software associated with a professional services project that
commenced in 2002. For the year ended December 31, 2002 and 2001, approximately
15.0% and 17.3%, respectively, of revenues before reimbursed expenses were from
BellSouth who is a related party. Pfizer accounted for approximately 13.7% of
revenues before reimbursed expenses for the year ended December 31, 2002. There
were no other customers that accounted for more than 10.0% of revenues before
reimbursed expenses for the years ended December 31, 2002 and 2001. The number
of our billable consultants decreased from approximately 360 at December 31,
2001 to approximately 182 at December 31, 2002 mainly due to our 2002
restructuring activities which are discussed below.
Revenues generated from our operating segments for the year ended
December 31, 2002 as compared to December 31, 2001 were as follows:
December 31,
-----------------------------
2002 2001 Change % Change
------------- ------------- ------------- -------------
US Consulting $ 37,203,000 $ 54,808,000 $ (17,605,000) (32.1)%
International Consulting 8,861,000 7,805,000 1,056,000 13.5%
Managed Security Services 3,896,000 7,467,000 (3,571,000) (47.8)%
------------- ------------- ------------- -------------
$ 49,960,000 $ 70,080,000 $ (20,120,000) (28.7)%
============= ============= ============= =============
The decrease in revenues in our US Consulting and Managed Security Services
segments was primarily due to difficult market conditions affecting the
technology industry in general and the telecommunications and enterprise sector
in particular. These sectors are experiencing a drastic downturn and that
downturn has adversely impacted our ability to secure new business. The increase
in our International Consulting segment was primarily attributable to a large
customer contract for which services were performed in the first half of 2002.
This contract generated approximately $1.4 million in revenue for our
international operations.
Gross Profit. Gross profit decreased 12.8% to $13.6 million for the
year ended December 31, 2002 from $15.6 million for the year ended December 31,
2001. As a percentage of revenues, gross profit increased to 27.2% for the year
ended December 31, 2002 from 22.3% for the year ended December 31, 2001. Gross
profit on professional services for the year ended December 31, 2002 was $13.2
million or 29.4% compared to $15.7 million or 23.7% for the year ended December
31, 2001. The increase in gross profit as a percentage of professional services
revenues is primarily a result of 116 reductions in billable headcount resulting
from our restructuring activities in addition to an improvement in utilization.
Gross profit on hardware and software sales for the year ended December 31, 2002
was $397,000 or 10.4% compared to $(99,000) or (5.0%) for the year ended
December 31, 2001. Included in gross profit for the year ended December 31, 2001
is $500,000 for the write-off of software inventory, which was no longer
considered saleable. Excluding the impact of this write-off, gross profit on
hardware and software sales was $401,000 or 20.1% for the year ended December
31, 2001. The decrease in gross profit as a percentage of hardware and software
sales, excluding the impact of the software inventory write-off, is a result of
a professional services project that commenced in 2002 with a lower resale
margin. Costs of revenues decreased 33.3% to $36.4 million for the year ended
December 31, 2002 from $54.5 million for the year ended December 31, 2001. Costs
of revenues attributable to professional services decreased 37.3% to $31.7
million for the year ended December 31, 2002 from $50.5 million for the year
ended December 31, 2001. This decrease in cost of revenues was due primarily to
a decrease in compensation and benefits paid to consultants as a result of 116
reductions in billable headcount resulting from our restructuring activities and
an average 10% salary reduction for all US employees which was implemented in
July 2002. Costs of revenues attributable to hardware and software sales
increased 63.6% to $3.4 million for the year ended December 31, 2002 from $2.1
million for the year ended December 31, 2001. Included in costs of revenues
attributable to hardware and software sales for the year ended December 31, 2001
is $500,000 for the write-off of software inventory, which was no longer
considered saleable. Excluding the impact of this write-off, costs of revenues
for hardware and software was $1.6 million. The increase in cost of revenues for
hardware and software was primarily due to one contract where the client
requested us to supply all hardware and software associated with a professional
services project that commenced in June 2002.
26
Cost of revenues and gross profit associated with our operating
segments for the year ended December 31, 2002 as compared to December 31, 2001
were as follows:
December 31,
-----------------------------
2002 2001 Change % Change
------------- ------------- ------------- -------------
Cost of Revenues:
US Consulting $ 27,982,000 $ 43,301,000 $ (15,319,000) (35.4)%
International Consulting 5,348,000 5,479,000 (131,000) (2.4)%
Managed Security Services 3,027,000 5,700,000 (2,673,000) (46.9)%
------------- ------------- ------------- -------------
$ 36,357,000 $ 54,480,000 $ (18,123,000) (33.3)%
============= ============= ============= =============
Gross Profit:
US Consulting $ 9,221,000 $ 11,507,000 $ (2,286,000) (19.9)%
International Consulting 3,513,000 2,326,000 1,187,000 51.0%
Managed Security Services 869,000 1,767,000 (898,000) (50.8)%
------------- ------------- ------------- -------------
$ 13,603,000 $ 15,600,000 $ (1,997,000) (12.8)%
============= ============= ============= =============
Gross Profit Margin:
US Consulting 24.8% 21.0%
International Consulting 39.6% 29.8%
Managed Security Services 22.3% 23.7%
The decrease in cost of revenues for our US Consulting, International Consulting
and Managed Security Services operating segments was due primarily to a decrease
in compensation and benefits paid to consultants as a result of 95, 8 and 13
reductions in billable headcount, respectively, resulting from our restructuring
activities and an average 10% salary reduction for all US employees which was
implemented in July 2002. Gross profit improved for the US Consulting and
International Consulting operating segments due to these reductions in cost and
an overall improvement in utilization.
Sales and Marketing Expenses. Sales and marketing expenses decreased
49.3% to $8.0 million for the year ended December 31, 2002 from $15.8 million
for the year ended December 31, 2001. As a percentage of revenues, sales and
marketing expenses decreased to 16.1% for the year ended December 31, 2002 from
22.6% for the year ended December 31, 2001. The decrease in absolute dollars was
primarily due to a decrease of $5.2 million in compensation and benefits paid
due to 19 reductions in headcount resulting from our restructuring activities
and an average 10% salary reduction for all US employees which was implemented
in July 2002, and a decrease of $949,000 in commissions paid as a result of
declining revenues for professional services and the merging of the sales forces
for US Consulting and Managed Security Services in 2002. The remaining $1.7
million decrease in sales and marketing expenses was a result of decreased
expenditures for marketing and selling efforts, such as conferences and
mailings, and an overall decline in travel costs as part of our cost cutting
measures undertaken in 2002.
General and Administrative Expenses. General and administrative
expenses decreased 51.6% to $20.4 million for the year ended December 31, 2002
from $42.1 million for the year ended December 31, 2001. As a percentage of
revenues, general and administrative expenses decreased to 40.8% for the year
ended December 31, 2002 from 60.0% for the year ended December 31, 2001. The
decrease in absolute dollars was primarily due to a decrease of $7.0 million in
compensation and benefits costs as a result of 21 reductions in headcount
resulting from our restructuring activities and an average 10% salary reduction
for all US employees which was implemented in July 2002, a decrease of $3.3
million in travel and entertainment and training costs also as a result of
reductions in headcount, a decrease of $4.6 million in bad debt expense, and a
decrease of $3.0 million in facilities and equipment leases resulting from our
restructuring activities. Such restructuring activities included a reduction in
our leased space from 11 locations, or approximately 90,000 square feet, at
December 31, 2001 to seven locations, or approximately 74,000 square feet, at
December 31, 2002. In addition to the four locations that were closed during
2002, we also closed eight locations, or approximately 40,000 square feet, in
2001 and reduced square footage at two locations from approximately 60,000
square feet to approximately 44,000 square feet. Bad debt expense for the year
ended December 31, 2002 and 2001 was $84,000 and $4.7 million, respectively. In
2001 we recorded an additional provision of approximately $1.9 million to
account for customers filing for federal bankruptcy protection, which created
significant uncertainty regarding our ability to collect these outstanding trade
accounts receivable balances. The remaining expense in 2001 was additional
provision based on our analysis of accounts receivable balances. Based on our
analysis of our accounts receivable balances in 2002 and the decline in
revenues, our provision for bad debt was significantly less than the prior year.
The remaining decrease of $3.8 million in general and administrative expenses
was attributable to a reduction in professional services and other
administrative costs primarily as a result of a decrease in nonrecurring search
fees incurred in 2001 for management level positions such as our VP of Sales,
Chief Executive Officer, and European Managing Director, a decrease in
nonrecurring human resource consulting fees incurred in 2001 as a result of
cost-cutting measures, and the reversal of reserves for legal liabilities that
were no longer considered probable in 2002.
27
Depreciation and Amortization. Depreciation and amortization decreased
40.5% to $1.7 million for the year ended December 31, 2002 from $2.9 million for
the year ended December 31, 2001. The decrease was attributable to a reduction
in the carrying value of property and equipment in 2002 and 2001 due to the
write-off of approximately $497,000 and $3.4 million, respectively, of property
and equipment resulting from our restructuring activities. Additionally, as a
result of our operating performance, the corresponding decline in our market
capitalization, the general economic environment, and our forecasted operating
results for the foreseeable future, we evaluated the carrying value of the
long-lived assets of our US Consulting and Managed Security Services reporting
units for impairment during June of 2002 in accordance with the provisions of
SFAS 144. Based on this review, we recorded an impairment charge during 2002
related to the write-off of the property and equipment for our US Consulting and
Managed Security Services reporting units of $4.2 million and $286,000,
respectively. The impact on depreciation and amortization expense as a result of
the impairment charge was approximately $985,000. Finally, our expenditures for
property and equipment decreased in 2002 to $912,000 from $7.4 million in 2001
as a result of our cost reduction efforts undertaken in 2002. We recorded
additional depreciation expense in 2002 for capitalized software that was placed
in service on January 1, 2002 of approximately $443,000.
Intangibles Amortization. Amortization of intangibles decreased to $2.0
million for the year ended December 31, 2002 from $21.9 million for the year
ended December 31, 2001. Effective January 1, 2002 we were required to adopt
SFAS 142 "Goodwill and Other Intangible Assets" (SFAS 142). SFAS 142 requires
that upon adoption, amortization of goodwill and indefinite lived intangibles
cease, and instead the carrying value of goodwill and indefinite lived
intangibles be evaluated for impairment on at least an annual basis. Intangibles
amortization for the year ended December 31, 2001 consisted of amortization for
all intangible assets, including goodwill, assembled workforce and tradenames.
During the year ended December 31, 2001 we recognized $18.5 of amortization
related to goodwill and indefinite lived intangible assets that were no longer
subject to amortization beginning January 1, 2002. For the year ended December
31, 2002, the intangibles amortization recorded was for intangible assets with
finite lives only. Such intangible assets were comprised of customer lists and
developed technology. As a result of our operating performance, the
corresponding decline in our market capitalization, the general economic
environment, and our forecasted operating results for the foreseeable future, we
evaluated the carrying value of the long-lived assets of our US Consulting and
Managed Security Services reporting units for impairment during June of 2002. An
impairment loss is recognized if the carrying amount of a long-lived asset group
is not recoverable. 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
loss 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 our long-lived assets for our US Consulting
and Managed Security Services reporting units, it was determined that the
carrying values of these assets were not recoverable. As a result, we recorded
an impairment charge during 2002 related to finite lived intangible assets,
consisting of customers lists and developed technology, of our US Consulting and
Managed Security Services reporting units of $3.4 million and $5.3 million,
respectively. The fair values of the asset groups were determined based on the
discounted cash flows expected to be generated from such asset groups over the
estimated remaining useful life of the principle asset in each group. No
amortization expense for finite lived intangible assets was recorded since
June 30, 2002.
Loss on Equipment. For the year ended December 31, 2001, we recognized
a loss of $443,000 for equipment that was not in service and did not have any
salvage value.
Impairment of Goodwill and Intangibles. As a result of our operating
performance, the corresponding decline in our market capitalization, the general
economic environment, and our forecasted operating results for the foreseeable
future, we evaluated the carrying value of the long-lived assets of our US
Consulting and Managed Security Services reporting units for impairment during
June of 2002. An impairment loss is recognized if the carrying amount of a
long-lived asset group is not recoverable. 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 loss 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 our long-lived assets
for our US Consulting and Managed Security Services reporting units, it was
determined that the carrying values of these assets were not recoverable. As a
result, we recorded an impairment charge during 2002 related to finite lived
intangible assets, consisting of customers lists and developed technology, of
our US Consulting and Managed Security Services reporting units of $3.4 million
and $5.3 million, respectively. The fair values of the asset groups were
determined based on the discounted cash flows expected to be generated from such
asset groups over the estimated remaining useful life of the principle asset in
each group. In December 2002, our German subsidiary, which is included in our
International Consulting reporting unit, filed for bankruptcy. The provisions of
SFAS 142 required that we review goodwill associated with our International
Consulting reporting unit for impairment as a result of the bankruptcy filing.
The Board of our German subsidiary took this bankruptcy action since it
determined the subsidiary could no longer pay its debts as they came due in
ordinary course. Based on this review, we determined that an impairment of
$561,000 existed at December 31, 2002 related to the goodwill of our
International Consulting reporting unit.
28
Due to revenue declines in the Synet and Global Integrity businesses in
2001 compared to prior periods and forecasted earnings and the overall
deterioration of market conditions in the enterprise sector, we reviewed
goodwill and the intangible assets for impairment in 2001. For the year ended
December 31, 2001, we recognized impairment losses of $18.2 million and $42.3
million for the difference between the estimated fair value of Synet and Global
Integrity, respectively, based on the future expected discounted cash flows and
the carrying amount of each of their assets and liabilities, including goodwill.
Of the 2001 impairment loss, $37.6 million and $22.9 million, respectively, was
related to our US Consulting and Managed Security Services reporting units.
Impairment of Property and Equipment. As a result of our operating
performance, the corresponding decline in our market capitalization, the general
economic environment, and our forecasted operating results for the foreseeable
future, we evaluated the carrying value of the long-lived assets of our US
Consulting and Managed Security Services reporting units for impairment during
June of 2002. An impairment loss is recognized if the carrying amount of a
long-lived asset group is not recoverable. 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 loss 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 our long-lived assets
for our US Consulting and Managed Security Services reporting units, it was
determined that the carrying values of these assets were not recoverable. As a
result, we recorded an impairment charge during 2002 related to property and
equipment of our US Consulting and Managed Security Services reporting units of
$4.2 million and $286,000, respectively. The fair values of the asset groups
were determined based on the discounted cash flows expected to be generated from
such asset groups over the estimated remaining useful life of the principle
asset in each group.
Restructuring and Other Charges. In January 2002, our management
foresaw the need to continue to lower the operating costs of the business given
continuing difficult market conditions. Therefore, we established a 2002
restructuring plan that included the following: (1) a reduction in our 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 year ended
December 31, 2002, we recorded restructuring charges of $5.8 million in
connection with our 2002 restructuring plan. Such charges consisted of $3.3
million in severance benefits and other related expenses for a headcount
reduction of 156 employees, $2.3 million in exit costs related to real estate
and electronic equipment leases for the closing of three domestic offices
reducing the square footage of space occupied from approximately 84,000 square
feet to approximately 74,000 square feet, and an increase to previously accrued
exit costs in the amount of $181,000 resulting from favorable and unfavorable
settlements and changes to subtenant assumptions for leased domestic offices. In
addition to these charges we recorded an additional $309,000 to restructuring
and other charges as a result of our German subsidiary filing for bankruptcy in
December 2002. Such amount consisted of the write-off of the net assets of our
German subsidiary in the amount of $284,000 and $25,000 in legal costs
associated with the bankruptcy. The Board of our German subsidiary took this
bankruptcy action since it determined it could no longer pay its debts as they
came due in ordinary course. In December 2001, we formed a strategic alliance
with an unaffiliated third party to outsource the monitoring services provided
by our Managed Security Services division. The restructuring charges related to
the 2002 restructuring plan and our German subsidiary filing for bankruptcy were
offset by $150,000 received for the sale of equipment written off to
restructuring charges in 2001 in connection with this outsourcing of our
monitoring services and $283,000 for the reversal of prior year accrued expenses
also in connection with the outsourcing of our monitoring services that were no
longer considered necessary.
In February 2001, our management foresaw the need to lower the
operating costs of the business given its near-term revenue projections.
Therefore, we established a plan that included the following: (1) a reduction in
our 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. For
the year ended December 31, 2001, we recorded restructuring charges of $9.3
million in connection with our 2001 restructuring plan. Such charges consisted
of $3.4 in severance benefits and other related expenses for a reduction in
headcount of 251 employees and $5.9 million in exit costs related to real estate
and electronic equipment leases for the closing of eight offices reducing the
square footage of space occupied by 40,000 square feet. As a result of the
outsourcing of our monitoring services, in December 2001 we reduced headcount by
12 employees and recorded restructuring charges of $4.4 million. Such charges
consisted of $315,000 in severance benefits, $798,000 in non-recoverable costs
to convert clients to this alliance partner and other related charges, and $3.3
million for the write-off of equipment and software development costs associated
with our security operations center, which will no longer be needed as a result
of the outsourcing.
Other charges for the year ended December 31, 2002 consisted of the
write-off of approximately a $1.7 million advance pursuant to a system
integrator agreement with a supplier of software. During 2002, the supplier
filed for bankruptcy. As we were acting as an agent of the supplier in the
arrangement for the resale of this software and the revenues were recognized on
a net basis, this write-off has been classified in restructuring and other
charges. Other charges for the year ended December 31, 2001 consisted of $1.0
million related to the write-off of internal software management tools for time
entry reporting as a result of our decision to implement a fully integrated
system that better suited our business needs.
29
Loss on Long-Term Investments in Related Parties. On March 22, 2001,
Paradigm4, Inc. ("Paradigm4") filed for federal bankruptcy protection and
subsequently ceased doing business. This action created significant uncertainty
regarding the carrying value of our investment in Paradigm4. As a result, we
recognized a loss of $1.0 million, the full value of our investment in
Paradigm4, for the year ended December 31, 2001. For the year ended December 31,
2001, we also recognized a loss on our $1.0 million investment in Three Pillars
due to management's determination that the value of the investment was impaired
based on the economic prospects of Three Pillars' business.
Noncash Charges for Stock-Based Compensation and Services. 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
charges for stock based compensation and services over the period that these
specific options vest. During the year ended December 31, 2002 and 2001, we
recorded approximately $119,000 and $276,000, respectively, of noncash charges
for stock-based compensation and services related to these options. The decrease
in expense attributable to these options is as a result of the cancellation of
options as a result of reductions in headcount, mainly resulting from our
restructuring activities. In October 2002, we adopted Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (SFAS
123). Prior to the adoption of SFAS 123, we accounted for our stock-based
compensation arrangements with our employees using the intrinsic value method in
accordance with the provisions of Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" (APB25), and complied with the
disclosure provisions of SFAS 123. SFAS 123 established a fair-value-based
method of accounting for stock-based compensation plans. Pursuant to the
transition provisions of SFAS 123, we were required to apply the fair value
method of accounting to all option grants issued on or after January 1, 2002. As
a result of adoption of SFAS 123, we recorded an additional charge to noncash
charges for stock-based compensation and services of $210,000 for the year ended
December 31, 2002. In October 2002, we implemented an employee voluntary stock
option exchange program whereby we offered to exchange certain outstanding
options to purchase shares of our common stock held by our eligible employees,
with exercise prices per share greater than or equal to $0.80, for new options
to purchase shares of our common stock (the "Offer to Exchange"). Under the
terms of the Offer to Exchange, the 193 participating employees had certain of
their existing options to purchase 4,085,860 shares of our common stock
cancelled as of October 18, 2002 and received options to purchase 3,139,424
shares of our common stock with an exercise price equal to the closing market
price of $0.22 per share on October 18, 2002.
Other Income (Expense). Other income for the year ended December 31,
2002 primarily consisted of a reduction in an acquisition related exit cost
accrual of approximately $921,000 as a result of the negotiation of a favorable
buyout of an existing lease which was assumed in connection with the Global
Integrity acquisition. The liability for such lease had been fully accrued as
part of the acquired assets and assumed liabilities of Global Integrity in
fiscal 2001. Other income for the year ended December 31, 2001 primarily
consisted of interest income.
Income Taxes. Income tax provision was $40,000 on pre-tax losses of
$38.6 million for the year ended December 31, 2002. For the year ended
December 31, 2001, the income tax benefit was $1.6 million on pre-tax losses of
$142.5 million. The effective tax rate was 0.1% and (1.1)% during 2002 and 2001,
respectively. The prior year deferred tax benefit was due to the recognition of
a benefit for net operating losses, which are expected to offset the income
generated as our deferred tax liabilities decrease.
Cumulative Effect of Change in Accounting Principle. Upon adoption of
SFAS 142 in 2002, we recorded a noncash charge of $23.3 million for the year
ended December 31, 2002 to reduce the carrying value of our goodwill and other
indefinite lived intangible assets, primarily consisting of acquired tradenames.
Years Ended December 31, 2001 and 2000
Revenues. Our principal source of revenues is fees from professional
services. Revenues decreased 23.2% to $70.1 million for the year ended
December 31, 2001 from $91.2 million for the year ended December 31, 2000.
Revenues from professional services decreased 22.4% to $66.2 million for the
year ended December 31, 2001 from $85.3 million for the year ended December 31,
2000. This decrease was primarily due to difficult market conditions in the
enterprise sector. Reimbursed expenses decreased 35.9% to $1.9 million for the
year ended December 31, 2001 from $2.9 million for the year ended December 31,
2000. This decrease was primarily attributable to the nature of the customer
contracts in addition to the overall decline in professional services revenues.
Revenues from hardware and software sales decreased 32.5% to $2.0 million for
the year ended December 31, 2001 from $3.0 million for the year ended December
31, 2000. This decrease was also primarily due to the nature of the customer
contracts in addition to the overall decline in professional services revenues.
For the year ended December 31, 2001 and 2000, approximately 17.3% and 10.2%,
respectively, of revenues before reimbursed expenses were from BellSouth, who is
a related party. There were no other customers that accounted for more than
10.0% of revenues before reimbursed expenses for the years ended December 31,
2001 and 2000. The number of our billable consultants decreased from
approximately 520 at December 31, 2000 to approximately 360 at December 31,
2001.
30
Revenues generated from our operating segments for the year ended
December 31, 2001 as compared to December 31, 2000 were as follows:
December 31,
-----------------------------
2001 2000 Change % Change
------------- ------------- ----------- -----------
US Consulting $ 54,808,000 $ 82,718,000 $(27,910,000) (33.7)%
International Consulting 7,805,000 8,279,000 (474,000) (5.7)%
Managed Security Services 7,467,000 199,000 7,268,000 3,652.3 %
------------- ------------- ------------ -----------
$ 70,080,000 $ 91,196,000 $(21,116,000) (23.2)%
============= ============= ============ ===========
The decrease in revenues in our US Consulting and International Consulting
segments were primarily due to difficult market conditions in the enterprise
sector. The increase in revenues in our Managed Security Services segment was
due to the acquisition of Global Integrity in December 2000.
Gross Profit. Gross profit decreased 59.6% to $15.6 million for the
year ended December 31, 2001 from $38.7 million for the year ended December 31,
2000. As a percentage of revenues, gross profit decreased to 22.3% for the year
ended December 31, 2001 from 42.4% for the year ended December 31, 2000. Gross
profit on professional services for the year ended December 31, 2001 was $15.7
million or 23.7% compared to $37.9 million or 44.4% for the year ended
December 31, 2000. The decrease in gross profit as a percentage of professional
services revenues is primarily a result of a decrease in utilization of our
consultants. Gross profit on hardware and software sales for the year ended
December 31, 2001 was $(99,000) or (5.0%) compared to $749,000 or 25.4% for the
year ended December 31, 2000. Included in gross profit for the year ended
December 31, 2001 is $500,000 for the write-off of software inventory, which was
no longer considered saleable. Excluding the impact of this write-off, gross
profit on hardware and software sales was $401,000 or 20.1% for the year ended
December 31, 2001. The decrease in gross profit as a percentage of hardware and
software sales, excluding the impact of the software inventory write-off, is a
result of lower resale margins on 2001 projects. Costs of revenues increased
3.7% to $54.5 million for the year ended December 31, 2001 from $52.5 million
for the year ended December 31, 2000. Costs of revenues attributable to
professional services increased 6.5% to $50.5 million for the year ended
December 31, 2001 from $47.4 million for the year ended December 31, 2000. This
increase in cost of revenues was due primarily to an increase in compensation
and benefits paid to consultants in the first six months of 2001 as a result of
increases in billable headcount that occurred in the latter part of 2000 offset
by a decrease in compensation and benefits paid to consultants as a result of
157 reductions in billable headcount resulting from our restructuring
activities. Costs of revenues attributable to hardware and software sales
decreased 5.0% to $2.1 million for the year ended December 31, 2001 from $2.2
million for the year ended December 31, 2000. Included in costs of revenues
attributable to hardware and software sales for the year ended December 31, 2001
is $500,000 for the write-off of software inventory, which was no longer
considered saleable. Excluding the impact of this write-off, costs of revenues
for hardware and software was $1.6 million. The decrease in cost of revenues for
hardware and software was due to a decline in client requests for us to supply
hardware and software associated with professional services projects.
Cost of revenues and gross profit associated with our operating
segments for the year ended December 31, 2001 as compared to December 31, 2000
were as follows:
December 31,
-----------------------------
2001 2000 Change % Change
------------- ------------- ------------- -------------
Cost of Revenues:
US Consulting $ 43,301,000 $ 48,819,000 $ (5,518,000) (11.3)%
International Consulting 5,479,000 3,636,000 1,843,000 50.7 %
Managed Security Services 5,700,000 87,000 5,613,000 6,451.7 %
------------- ------------- ------------- -------------
$ 54,480,000 $ 52,542,000 $ 1,938,000 3.7 %
============= ============= ============= =============
Gross Profit:
US Consulting $ 11,507,000 $ 33,899,000 $ (22,392,000) (66.1)%
International Consulting 2,326,000 4,643,000 (2,317,000) (49.9)%
Managed Security Services 1,767,000 112,000 1,655,000 1,477.7 %
------------- ------------- ------------- -------------
$ 15,600,000 $ 38,654,000 $ (23,054,000) (59.6)%
============= ============= ============= =============
Gross Profit Margin:
US Consulting 21.0% 41.0%
International Consulting 29.8% 56.1%
Managed Security Services 23.7% 56.3%
31
The decrease in cost of revenues for our US Consulting operating segment was due
primarily to a decrease in compensation and benefits paid to consultants as a
result of 134 reductions in billable headcount resulting from our restructuring
activities. The increase in cost of revenues for our International Consulting
segment was due primarily to the increase in compensation and benefits paid to
consultants as a result of the formation of our German subsidiary in 2001 offset
by a decrease in compensation and benefits paid to consultants as a result of 23
reductions in billable headcount resulting from our restructuring activities.
The increase in cost of revenues in our Managed Security Services segment was
due to the acquisition of Global Integrity in December 2000. Gross profit
declined for the all operating segments due to a decrease in utilization of our
consultants.
Sales and Marketing Expenses. Sales and marketing expenses increased
28.8% to $15.8 million for the year ended December 31, 2001 from $12.3 million
for the year ended December 31, 2000. As a percentage of revenues, sales and
marketing expenses increased to 22.6% for the year ended December 31, 2001 from
13.5% for the year ended December 31, 2000. The increase in absolute dollars was
primarily due to an increase of $2.6 million in compensation and benefits paid
due to the hiring of additional personnel, an increase of $508,000 in travel and
other selling related expenditures, and an increase of $818,000 in commissions
paid. The increase in commissions was attributable to the fact that we had two
separate sales forces for US Consulting and Managed Security Services in 2001.
In certain instances, both sales forces received commission for the same sale to
compensate both the sales person responsible for managing the customer
relationship and the sales person that sold the services. In 2002, the two sales
forces were merged into one sales force. These increases were offset by a
decrease in marketing expenses of $368,000.
General and Administrative Expenses. General and administrative
expenses increased 30.5% to $42.1 million for the year ended December 31, 2001
from $32.2 million for the year ended December 31, 2000. As a percentage of
revenues, general and administrative expenses increased to 60.0% for the year
ended December 31, 2001 from 35.3% for the year ended December 31, 2000. The
increase in absolute dollars was primarily due to an increase of $3.9 million in
compensation and benefits paid due to the hiring of additional personnel and
$2.9 million in facilities and equipment leases. In addition, there was an
increase of $3.3 million in professional services and other administrative costs
primarily as a result of nonrecurring search fees incurred in 2001 for
management level positions such as our VP of Sales, Chief Executive Officer, and
European Managing Director, nonrecurring human resource consulting fees incurred
in 2001, and an increase in reserves for legal liabilities in 2001 which were
considered both probable and estimatable. These increases were offset by a
decrease in bad debt expense of approximately $231,000. Bad debt expense for the
years ended December 31, 2001 and 2000 was $4.7 million and $4.9 million,
respectively. In 2001 and 2000, we recorded an additional provision of
approximately $1.9 million and $4.0 million, respectively, to account for
customers filing for federal bankruptcy protection, which created significant
uncertainty regarding our ability to collect these outstanding trade accounts
receivable balances. The remaining expense in 2001 and 2000 was additional
provision based on our analysis of accounts receivable balances.
Depreciation and Amortization. Depreciation and amortization increased
73.4% to $2.9 million for the year ended December 31, 2001 from $1.7 million for
the year ended December 31, 2000. The increase was attributable to purchases of
additional computer equipment, furniture and leasehold improvements during 2000,
which were subject to a full year of depreciation and amortization in 2001,
offset by the write-off of certain fixed assets in connection with our 2001
restructuring and acquisition plans.
Intangibles Amortization. Amortization of intangibles increased to
$21.9 million for the year ended December 31, 2001 from $2.9 million for the
year ended December 31, 2000. Intangibles amortization for the years ended
December 31, 2001 and 2000 consisted of $853,000 related to the acquisition of
Network Resource Consultants and Company B.V. (NRCC) in August 1999, $6.1
million and $1.4 million, respectively, related to the acquisition of Synet in
October 2000, and $15.0 million and $650,000, respectively, related to the
acquisition of Global Integrity in December 2000.
Loss on Equipment. For the year ended December 31, 2001, we recognized
a loss of $443,000 for equipment that was not in service and deemed to have no
salvage value.
Impairment of Goodwill and Intangibles. Due to revenue declines in the
Synet and Global Integrity businesses in 2001 compared to prior periods and
forecasted earnings and the overall deterioration of market conditions in the
enterprise sector, we reviewed goodwill and the intangible assets for impairment
in 2001. For the year ended December 31, 2001, we recognized impairment losses
of $18.2 million and $42.3 million for the difference between the estimated fair
value of Synet and Global Integrity, respectively, based on the future expected
discounted cash flows and the carrying amount of each of their assets and
liabilities, including goodwill. Of the 2001 impairment loss, $37.6 million and
$22.9 million, respectively, was related to our US Consulting and Managed
Security Services reporting units.
32
Restructuring and Other Charges. In February 2001, our management
foresaw the need to lower the operating costs of the business given its
near-term revenue projections. Therefore, we established a plan that included
the following: (1) a reduction in our 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. For the year ended December 31,
2001, we recorded restructuring charges of $9.3 million in connection with our
2001 restructuring plan. Such charges consisted of $3.4 million in severance
benefits and other related expenses for a reduction in headcount of 251
employees and $5.9 million in exit costs related to real estate and electronic
equipment for the closing of eight offices reducing the square footage of space
occupied by 40,000 square feet. In December 2001, we formed a strategic alliance
with an unaffiliated third party to outsource the monitoring services provided
by our Managed Security Services division. As a result of the outsourcing of our
monitoring services, in December 2001 we reduced headcount by 12 employees and
recorded restructuring charges of $4.4 million. Such charges consisted of
$315,000 in severance benefits, $798,000 in non-recoverable costs to convert
clients to this alliance partner and other related charges, and $3.3 million for
the write-off of equipment and software development costs associated with our
security operations center, which will no longer be needed as a result of the
outsourcing.
Additionally, included in the financial statement caption for the year
ended December 31, 2001 is $1.0 million related to the write-off of internal
software management tools for time entry reporting as a result of our decision
to implement a fully integrated system that better suited our business needs.
Loss on Long-Term Investments in Related Parties. On March 22, 2001,
Paradigm4, Inc. ("Paradigm4") filed for federal bankruptcy protection. This
action created significant uncertainty regarding the carrying value of our
investment in Paradigm4. As a result, we recognized a loss on our $1.0 million
investment in Paradigm4 for the year ended December 31, 2001. For the year ended
December 31, 2001, we also recognized a loss on our $1.0 million investment in
Three Pillars due to management's determination that the value of the investment
was impaired based on the economic prospects of Three Pillars' business.
Noncash Charges for Stock-Based Compensation and Services. 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
charges for stock-based compensation and services over the period that these
specific options vest. During the year ended December 31, 2001 and 2000, we
recorded approximately $276,000 and $158,000, respectively, of noncash charges
for stock-based compensation and services related to these options
Other Income (Expense). Other income decreased to $2.5 million for the
year ended December 31, 2001 from $6.8 million for the year ended December 31,
2000. This decrease was primarily due to a decrease in interest income as a
result of the utilization of cash and cash equivalents to fund current operation
needs and the Synet and Global Integrity acquisitions, in addition to an overall
decline in interest rates.
Income Taxes. For the year ended December 31, 2001, the income tax
benefit was $1.6 million on pre-tax losses of $142.5 million. For the year ended
December 31, 2000, the income tax provision was $95,000 on pre-tax losses of
$3.8 million. The effective tax rate was (1.1)% and 2.5% during 2001 and 2000,
respectively. The 2001 deferred tax benefit was due to the recognition of a
benefit for net operating losses, which are expected to offset the income
generated as our deferred tax liabilities decrease.
33
Quarterly Results of Operations
The following table sets forth unaudited quarterly statement of
operations data (in thousands) for each of the eight quarters in the period
ended December 31, 2002 and the percentage of our revenues represented by each
item in the respective quarters. In the opinion of management, all necessary
adjustments, consisting only of normal recurring adjustments, have been included
in the amounts stated below to present fairly the unaudited quarterly results
when read in conjunction with our financial statements and notes. The unaudited
results of operations for any quarter are not necessarily indicative of results
for any future period.
Quarter Ended
--------------------------------------------
Mar. 31, June 30, Sept. 30, Dec. 31,
2002 2002 2002 2002
(1)
--------- -------- --------- --------
Revenues:
Professional services ............................................... $14,106 $11,556 $10,339 $ 8,890
Reimbursed expenses.................................................. 401 323 290 239
Hardware and software sales ......................................... 524 79 1,894 1,319
-------- -------- ------- --------
Total revenues..................................................... 15,031 11,958 12,523 10,448
Cost of Revenues:
Professional services ............................................... 10,171 8,895 6,907 5,712
Reimbursed expenses.................................................. 401 323 290 239
Hardware and software .............................................. 493 64 1,746 1,116
-------- -------- ------- --------
Total cost of revenues............................................. 11,065 9,282 8,943 7,067
-------- -------- ------- --------
Gross profit.......................................................... 3,966 2,676 3,580 3,381
Operating Expenses:
Selling and marketing ............................................... 2,742 2,232 1,745 1,308
General and administrative .......................................... 6,441 6,499 4,590 2,842
Depreciation and amortization ....................................... 774 732 104 98
Intangibles amortization ............................................ 981 980 -- --
Loss on equipment.................................................... -- -- -- --
Impairment of goodwill and intangibles............................... -- 8,744 -- 561
Impairment of property and equipment................................. -- 4,510 -- --
Restructuring and other charges...................................... 933 4,830 296 1,409
Loss on long-term investments in related parties..................... -- -- -- --
Noncash charges for stock-based compensation and services............ 36 37 29 227
-------- -------- ------- --------
Operating loss........................................................ (7,941) (25,888) (3,184) (3,064)
Other (expense) income, net........................................... (446) 433 1,034 102
Interest income, net.................................................. 135 107 74 60
-------- -------- ------- --------
Loss before income tax provision (benefit) and cumulative
effect of change in accounting principle............................. (8,252) (25,348) (2,076) (2,902)
Income tax provision (benefit) ....................................... -- -- -- 40
-------- -------- ------- --------
Loss before cumulative effect of change in accounting principle....... (8,252) (25,348) (2,076) (2,942)
Cumulative effect of change in accounting principle(1)................ (23,308) -- -- --
-------- -------- ------- --------
Net loss.............................................................. $(31,560) $(25,348) $(2,076) $ (2,942)
======== ======== ======= ========
Percentage of Total Revenues
-------------------------------------------
Revenues:
Professional services ............................................... 93.8% 96.6% 82.6% 85.1%
Reimbursed expenses ................................................. 2.7 2.7 2.3 2.3
Hardware and software sales.......................................... 3.5 0.7 15.1 12.6
------- ------- ------- --------
Total revenues..................................................... 100.0 100.0 100.0 100.0
Cost of Revenues:
Professional services ............................................... 67.7 74.4 55.2 54.7
Reimbursed expenses.................................................. 2.7 2.7 2.3 2.3
Hardware and software ............................................... 3.3 0.5 13.9 10.7
------- ------- ------- --------
Total cost of revenues............................................. 73.7 77.6 71.4 67.7
------- ------- ------- --------
Gross profit.......................................................... 26.3 22.4 28.6 32.3
Operating Expenses:
Selling and marketing ............................................... 18.2 18.7 13.9 12.5
General and administrative .......................................... 42.9 54.4 36.7 27.2
Depreciation and amortization ....................................... 5.1 6.1 0.8 0.9
Intangibles amortization ............................................ 6.5 8.2 -- --
Loss on equipment.................................................... -- -- -- --
Impairment of goodwill and intangibles............................... -- 73.1 -- 5.4
Impairment of property and equipment................................. -- 37.7 -- --
Restructuring and other charges...................................... 6.2 40.4 2.5 13.5
Loss on long-term investments in related parties..................... -- -- -- --
Noncash charges for stock-based compensation and services............ 0.2 0.3 0.2 2.2
------- ------- ------- --------
Operating loss........................................................ (52.8) (216.5) (25.5) (29.4)
Other (expense) income, net........................................... (3.0) 3.6 8.3 1.0
Interest income, net.................................................. 0.9 0.9 0.6 0.6
------- ------- ------- --------
Loss before income tax provision (benefit) and cumulative
effect of change in accounting principle............................. (54.9) (212.0) (16.6) (27.8)
Income tax provision (benefit) ....................................... -- -- -- 0.4
------- ------- ------- --------
Loss before cumulative effect of change in accounting principle....... (54.9) (212.0) (16.6) (28.2)
Cumulative effect of change in accounting principle (1)............... (155.1) -- -- --
------- ------- ------- --------
Net loss.............................................................. (210.0)% (212.0)% (16.6)% (28.2)%
======= ======== ======== ========
(1) The Company has restated the results for the three months ended March 31,
2002 to reflect the adoption of Statement of Financial Accounting Standard No.
142, "Goodwill and Other Intangible Assets."
34
Quarter Ended
--------------------------------------------
Mar. 31, June 30, Sept. 30, Dec. 31,
2001 2001 2001 2001
--------- -------- --------- --------
Revenues:
Professional services ............................................... $20,358 $17,841 $14,351 $13,667
Reimbursed expenses.................................................. 580 550 405 337
Hardware and software sales ......................................... 401 492 677 421
-------- -------- -------- --------
Total revenues..................................................... 21,339 18,883 15,433 14,425
Cost of Revenues:
Professional services ............................................... 15,211 12,868 11,677 10,762
Reimbursed expenses.................................................. 580 550 405 337
Hardware and software .............................................. 283 896 618 293
-------- -------- -------- --------
Total cost of revenues............................................. 16,074 14,314 12,700 11,392
-------- -------- -------- --------
Gross profit.......................................................... 5,265 4,569 2,733 3,033
Operating Expenses:
Selling and marketing ............................................... 4,560 4,729 3,632 2,909
General and administrative .......................................... 11,885 12,054 10,435 7,684
Depreciation and amortization ....................................... 766 953 583 571
Intangibles amortization ............................................ 6,375 6,300 6,424 2,834
Loss on equipment.................................................... -- -- 443 --
Impairment of goodwill and intangibles............................... -- -- 60,485 --
Impairment of property and equipment................................. -- -- -- --
Restructuring and other charges...................................... 641 3,663 4,571 5,797
Loss on long-term investments in related parties..................... 1,000 -- 1,000 --
Noncash charges for stock-based compensation and services ........... 110 108 83 (25)
-------- -------- -------- --------
Operating loss........................................................ (20,072) (23,238) (84,923) (16,737)
Other income (expense), net........................................... 22 (76) 104 (101)
Interest income, net.................................................. 1,063 668 571 211
-------- -------- -------- --------
Loss before income tax provision (benefit) and cumulative
effect of change in accounting principle............................. (18,987) (22,646) (84,248) (16,627)
Income tax provision (benefit) ....................................... -- -- -- (1,635)
-------- -------- -------- --------
Loss before cumulative effect of change in accounting principle....... (18,987) (22,646) (84,248) (14,992)
Cumulative effect of change in accounting principle................... -- -- -- --
-------- -------- -------- --------
Net loss.............................................................. $(18,987) $(22,646) $(84,248) $(14,992)
======== ======== ======== ========
Percentage of Total Revenues
-------------------------------------------
Revenues:
Professional services ............................................... 95.4% 94.5% 93.0% 94.8%
Reimbursed expenses.................................................. 2.7 2.9 2.6 2.3
Hardware and software sales ......................................... 1.9 2.6 4.4 2.9
------- ------- ------- --------
Total revenues..................................................... 100.0 100.0 100.0 100.0
Cost of Revenues:
Professional services ............................................... 71.3 68.1 75.7 74.6
Reimbursed expenses.................................................. 2.7 2.9 2.6 2.3
Hardware and software ............................................... 1.3 4.7 4.0 2.0
------- ------- ------- --------
Total cost of revenues............................................. 75.3 75.7 82.3 78.9
------- ------- ------- --------
Gross profit.......................................................... 24.7 24.3 17.7 21.1
Operating Expenses:
Selling and marketing ............................................... 21.4 25.0 23.5 20.2
General and administrative .......................................... 55.6 63.9 67.6 53.3
Depreciation and amortization ....................................... 3.6 5.0 3.8 4.0
Intangibles amortization ............................................ 29.9 33.4 41.6 19.6
Loss on equipment.................................................... -- -- 2.9 --
Impairment of goodwill and intangibles............................... -- -- 391.9 --
Impairment of property and equipment................................. -- -- -- --
Restructuring and other charges...................................... 3.0 19.4 29.6 40.2
Loss on long-term investments in related parties..................... 4.7 -- 6.5 --
Noncash charges for stock-based compensation and services ........... 0.5 0.6 0.5 (0.2)
------- ------- ------- --------
Operating loss........................................................ (94.0) (123.0) (550.2) (116.0)
Other income (expense), net........................................... 0.1 (0.4) 0.7 (0.7)
Interest income, net.................................................. 5.0 3.5 3.7 1.5
------- ------- ------- --------
Loss before income tax provision (benefit) and cumulative
effect of change in accounting principle........................ (88.9) (119.9) (545.8) (115.2)
Income tax provision (benefit) .................................. -- -- -- (11.3)
------- ------- ------- --------
Loss before cumulative effect of change in accounting principle.. (88.9) (119.9) (545.8) (103.9)
Cumulative effect of change in accounting principle.............. -- -- -- --
------- ------- ------- --------
Net loss.............................................................. (88.9)% (119.9)% (545.8)% (103.9)%
======= ======== ======== =========
35
We have historically experienced significant quarterly fluctuations in
our revenues and results of operations and expect these fluctuations to
continue. Factors causing these variations include the number, timing, scope and
contractual terms of client projects, delays incurred in the performance of such
projects, accuracy of estimates of resources and time required to complete
ongoing projects, and general economic conditions. In addition, our future
revenues and operating results may fluctuate as a result of changes in pricing
in response to customer demand and competitive pressures, the ratio of
fixed-price contracts versus time-and-expense contracts and the timing of
collection of accounts receivable. A high percentage of our operating expenses,
particularly personnel and rent, are relatively fixed in advance of any
particular quarter. As a result, unanticipated variations in the number and
timing of our projects or in employee utilization rates may cause significant
variations in operating results in any particular quarter, and could result in
losses. Any significant shortfall of revenues in relation to our expectations,
any material reduction in utilization rates for our consultants, an
unanticipated termination of a major project, a client's decision not to pursue
a new project or proceed to succeeding stages of a current project, or the
completion during a quarter of several major customer projects could require us
to pay underutilized employees and have a material adverse effect on our
business, results of operations and financial condition.
Our quarterly operating results are also subject to certain seasonal
fluctuations. Demand for our services may be lower in the fourth quarter due to
reduced activity during the holiday season and fewer working days for those
customers that curtail operations during this period. These and other seasonal
factors may contribute to fluctuations in our operating results from quarter to
quarter.
Liquidity and Capital Resources
We have financed our operations through the sale of equity securities
and cash flows from operations. As of December 31, 2002, we had approximately
$19.5 million in cash and cash equivalents and $1.9 million in restricted cash
backing letters of credit issued pursuant to certain operating real estate and
equipment lease agreements and a customer contract.
Net cash used in operating activities decreased to $22.1 million for
2002 from $37.1 million in 2001. This decrease was primarily attributable to a
reduction in the operating loss for the year ended December 31, 2002 as compared
to the year ended December 31, 2001. We experienced a decrease in accounts
payable and accrued expenses and other current liabilities for the year ended
December 31, 2002 of approximately $4.8 million and $5.7 million, respectively.
Such decreases were attributable to approximately $2.4 million paid as an
advance pursuant to a system integrator agreement with a supplier of software,
approximately $982,000 for the payment of retention bonuses to employees of
Global Integrity prior to the acquisition who achieved their one year
anniversary with the Company and therefore qualified for the retention bonus,
and approximately $609,000 in lease termination fees for office space abandoned
in 2001. We also experienced an increase in restricted cash of $1.1 million in
2002 related to a new equipment operating lease and a contractual obligation in
connection with a customer contract entered into in 2002. These net outflows of
cash in 2002 were offset by net inflows of cash as a result of decreases in
accounts receivable and related party receivables of approximately $6.0 million
and $504,000, respectively. The decrease in accounts receivable and related
party receivables was primarily attributable to increased collection efforts and
declining revenues due to difficult market conditions affecting the technology
industry in general and the telecommunications and enterprise sector in
particular. These sectors are experiencing a drastic downturn and that downturn
has adversely impacted our ability to secure new business. Net cash used in
operating activities increased to $37.1 million for 2001 from $2.0 million in
2000. This increase was primarily attributable to an increase in the operating
loss for the year ended December 31, 2001 as compared to the year ended December
31, 2000. We experienced a decrease in accrued expenses and other current
liabilities of approximately $4.0 million and a decrease of $2.1 million in
deferred income for the year ended December 31, 2001. We also recorded a $3.5
million advance pursuant to a system integrator agreement with a supplier of
software of which $2.2 million remained at December 31, 2001. These net outflows
of cash in 2001 were offset by net inflows of cash as a result of decreases in
accounts receivable, related party receivables and unbilled revenues of $6.6
million, $3.7 million and $2.8 million, respectively. Such decreases were
attributable to increased collection efforts and declining revenues due to
difficult market conditions. Accounts payable in 2001 increased by $2.4 million
of which approximately $1.5 million related to an advance pursuant to a system
integrator agreement.
36
Net cash used in investing activities was $870,000 and $3.6 million,
respectively, for the years ended December 31, 2002 and 2001. Capital
expenditures were $912,000 for the year ended December 31, 2002 and primarily
consisted of computer equipment and leasehold improvements. Capital expenditures
were $7.5 million for the year ended December 31, 2001. Such capital
expenditures consisted of approximately $5.0 million for computer equipment,
office furniture, and leasehold improvements in connection with the investment
in our infrastructure and approximately $2.5 million of costs incurred in
connection with the development of software to be used for internal purposes.
The decline in the use of cash for capital expenditures in 2002 as compared to
2001 was attributable to our cost cutting efforts undertaken in 2002. We also
generated approximately $3.8 million in net proceeds from the sale and purchase
of marketable securities to fund operations for the year ended December 31,
2001. Net cash used in investing activities for the year ended December 31, 2000
was $53.6 million. A significant use of cash in 2000 resulted from $43.3 million
net cash paid in the acquisitions of Synet and Global Integrity, $6.9 million
paid for computer equipment, office furniture, and leasehold improvements in
connection with the investment in our infrastructure and $2.0 million paid in
connection with long-term investments in related parties.
Net cash provided by financing activities was $921,000, $2.0 million
and $45.9 million for the years ended December 31, 2002, 2001 and 2000,
respectively. Cash provided by financing activities for 2002 and 2001 primarily
resulted from the receipt of proceeds from the exercise of options of $885,000
and $1.9 million, respectively, and the sale of common stock in connection with
our 1999 Employee Stock Purchase Plan of $62,000 and $286,000, respectively,
offset by payments made under capital lease obligations of $76,000 and $156,000,
respectively. Additionally, in 2002 we generated $50,000 in proceeds from the
sale of common stock to an officer. Cash provided by financing activities for
2000 primarily resulted from the receipt of approximately $39.8 million in net
proceeds from the sale of common stock in a follow-on offering, $3.6 million in
proceeds from the exercise of stock options and $2.6 million in proceeds from
the sale of common stock in connection with our 1999 Employee Stock Purchase
Plan.
We have commitments to make future payments under various lease
agreements for computer equipment, office furniture and office space. Future
commitments under these leases are as follows:
--------------------------------------------------------------------------------------------------------------------------------
Payments Due By Period
--------------------------------------------------------------------------------------------------------------------------------
Contractual Cash Total Less than 1 year 1-3 years 4-5 years After 5 years
Obligations
--------------------------------------------------------------------------------------------------------------------------------
Capital Lease 57,579 48,969 8,610 - -
Obligations
--------------------------------------------------------------------------------------------------------------------------------
Operating Leases 8,688,991 1,994,488 3,559,671 1,567,416 1,567,416
--------------------------------------------------------------------------------------------------------------------------------
For the year ended December 31, 2002 we negotiated favorable buyouts of
three existing real estate operating leases for approximately $609,000. As a
result of such buyouts, we reduced our expected future minimum lease payment
obligation by approximately $3.0 million.
We are required under the terms of certain lease agreements to provide
letters of credit. The credit facility agreement used to provide these financial
guarantees places restrictions on our cash and cash equivalents. Cash of $1.4
million and $782,000, respectively, at December 31, 2002 and 2001 was pledged as
collateral under this agreement.
In August 2002, we were required under the terms of a customer contract
to provide a letter of credit for the value of services to be performed. The
credit facility agreement used to provide this financial guarantee places
restrictions on our cash and cash equivalents until the services are rendered to
the customer. The services are expected to be fully rendered by June 30, 2003.
Cash of $518,000 as of December 31, 2002 was pledged as collateral under this
agreement.
We believe that our existing cash and cash equivalents will be
sufficient to meet our anticipated needs for working capital and capital
expenditures for at least the next twelve months. If cash on hand and cash
generated from operations is insufficient to satisfy our liquidity requirements,
we may seek to sell additional equity or debt securities or to obtain credit
facilities. 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.
In October 2002, we implemented an employee voluntary stock option
exchange program whereby we offered to exchange certain outstanding options to
purchase shares of our common stock held by our eligible employees, with
exercise prices per share greater than or equal to $0.80, for new options to
purchase shares of our common stock (the "Offer to Exchange"). Under the terms
of the Offer to Exchange, the 193 participating employees had certain of their
existing options to purchase 4,085,860 shares of our common stock cancelled as
of October 18, 2002 and received options to purchase 3,139,424 shares of our
common stock with an exercise price equal to the closing market price of $0.22
per share on October 18, 2002. All new options were granted under the 1999 Stock
Incentive Plan, as amended. Each new option vests in equal monthly installments
in accordance with a four year vesting schedule beginning on the date of grant.
However, the vesting period was accelerated based on years of service with us
measured from the date of grant. Employees who held over 500,000 options, the
maximum number of options that may be issued per year to a single employee
pursuant to our 1999 Stock Incentive Plan, were only permitted to receive up to
500,000 new options pursuant to the Offer to Exchange. Therefore, we also
re-priced 1,500,000 of our Chief Executive Officer's outstanding options to give
these options the same terms as if he had been able to fully participate in the
Offer to Exchange.
Through December 31, 2002, we have not entered into any off balance
sheet arrangements or transactions with unconsolidated entities or other
persons.
37
Recent Accounting Pronouncements
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. We believe the adoption of SFAS 143 will not have a material impact on
our consolidated financial position or results of operations.
In April 2002, the FASB issued Statement of Financial Accounting
Standard No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of
FASB Statement No. 13, and Technical Corrections" (SFAS 145). 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 us for the year ending December 31, 2003. We believe that
the adoption of this statement will not have a significant impact on our
consolidated financial position or results of operations.
In July 2002, the Financial Accounting Standards Board issued
SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities"
(SFAS 146). SFAS 146 will supersede EITF 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 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 146 is
to be applied prospectively to exit or disposal activities initiated after
December 31, 2002. We believe that the adoption of this statement will not have
a significant impact on our consolidated financial position or results of
operations.
In November 2002, the FASB issued Interpretation No. 45 "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness to Others" which elaborates on the disclosures to be
made by a guarantor in its interim and annual financial statements about its
obligations under certain guarantees that it has issued. It also clarifies that
a guarantor is required to recognize, at the inception of a guarantee, a
liability for the fair value of the obligation undertaken in issuing the
guarantee. The initial recognition and measurement provisions of this
Interpretation are applicable on a prospective basis to guarantees issued or
modified after December 31, 2002. The disclosure requirements in this
Interpretation are effective for financial statements of interim or annual
periods ending after December 15, 2002. We have provided information regarding
commitments and contingencies relating to guarantees in Note 15 to our
consolidated financial statements.
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation -- Transition and
Disclosure -- an amendment of FASB Statement No. 123" (SFAS 148). SFAS 148
amends Statement of Financial Accounting Standards No. 123, "Accounting for
Stock-Based Compensation" (SFAS 123) to provide alternative methods to account
for the transition from the intrinsic value method of recognition of stock-based
employee compensation in accordance with Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" to the fair value recognition
provisions under SFAS 123. We adopted the recognition provisions of SFAS 123 as
of January 1, 2002 pursuant to the prospective method of adoption required by
SFAS 123. SFAS 148 provides two additional methods of transition and will no
longer permit the SFAS 123 prospective method to be used for fiscal years
beginning after December 15, 2003. In addition, SFAS 148 amends the disclosure
requirements of SFAS 123 to require prominent disclosure in both annual and
interim financial statements about the method of accounting for stock-based
employee compensation and the proforma effects had the fair value recognition
provisions of SFAS 123 been used for all periods presented. We have adopted the
annual disclosure provisions of SFAS 148 in Note 2 to the consolidated financial
statements. The adoption of SFAS 148 will not have a significant impact on our
consolidated results of operations and financial position.
38
Item 7A. Quantitative and Qualitative Disclosures 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, with the
exception of capital leases. 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.
Item 8. Financial Statements and Supplementary Data
39
PREDICTIVE SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE
Page
----
Report of Deloitte & Touche LLP.................................................................... 41
Report of Arthur Andersen LLP...................................................................... 43
Consolidated Balance Sheets as of December 31, 2002 and 2001....................................... 44
Consolidated Statements of Operations for the Years Ended December 31, 2002, 2001 and 2000......... 45
Consolidated Statements of Stockholders' Equity and Comprehensive Loss for the Years
Ended December 31, 2002, 2001 and 2000........................................................... 46
Consolidated Statements of Cash Flows for the Years Ended December 31, 2002, 2001 and 2000......... 48
Notes to Consolidated Financial Statements......................................................... 50
Schedule II - Schedule of Valuation and Qualifying Accounts........................................ 74
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
Predictive Systems, Inc.
New York, New York
We have audited the accompanying consolidated balance sheet of Predictive
Systems, Inc. and subsidiaries (the "Company") as of December 31, 2002, and the
related consolidated statements of operations, stockholders' equity and
comprehensive loss, and of cash flows for the year then ended. Our audit also
included the 2002 financial statement schedule listed in the Index at Item 15.
These financial statements and the financial statement schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on the 2002 financial statements and the financial statement schedule
based on our audit. The financial statements of the Company as of December 31,
2001 and for each of the years in the two-year period then ended, before: (a)
the inclusion of the transitional disclosures required by Statement of Financial
Accounting Standards ("SFAS") No. 142 "Goodwill and Other Intangible Assets"
("SFAS 142") as discussed in Note 7, (b) the revision of the disclosure of
proforma stock-based compensation expense, proforma net loss and proforma basic
and diluted net loss per share as discussed in Note 2 and (c) the
reclassification in the statements of operations of Revenues and Cost of
Revenues for reimbursed expenses required by Emerging Issues Task Force Issue
No. 01-14 "Income Statement Characterization of Reimbursements Received for
"Out-of-Pocket" Expenses Incurred" ("EITF 01-14") as discussed in Note 2 to the
financial statements, were audited by other auditors who have ceased operations.
Those auditors expressed an unqualified opinion on those financial statements
and stated that such 2001 and 2000 financial statement schedule, when considered
in relation to the 2001 and 2000 basic financial statements taken as a whole,
presented fairly, in all material respects, the information set forth therein,
in their report dated February 6, 2002.
We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the 2002 consolidated financial statements present fairly, in
all material respects, the financial position of Predictive Systems, Inc. and
subsidiaries as of December 31, 2002, and the results of their operations and
their cash flows for the year then ended, in conformity with accounting
principles generally accepted in the United States of America. Also, in our
opinion, the 2002 financial statement schedule, when considered in relation to
the basic 2002 consolidated financial statements taken as a whole, presents
fairly in all material respects, the information set forth therein.
41
As discussed above, the financial statements of the Company as of December 31,
2001, and for each of the years in the two-year period then ended, were audited
by other auditors who have ceased operations and (a) as described in Note 7,
those financial statements have been revised to include the transitional
disclosures required by SFAS 142 which was adopted by the Company as of January
1, 2002. Our audit procedures with respect to the disclosures in Note 7 with
respect to 2001 and 2000 included (i) comparing the previously reported net loss
to the previously issued financial statements and the adjustments to reported
net loss representing amortization expense (including any related tax effects)
recognized in those periods related to goodwill and intangible assets that are
no longer being amortized to the Company's underlying records obtained from
management, and (ii) testing the mathematical accuracy of the reconciliation of
adjusted net loss to reported loss, and the related earnings-per-share amounts.
In our opinion, the disclosures for 2001 and 2000 in Note 7 are appropriate. (b)
as discussed above, the notes to the financial statements of the Company for the
years ended December 31, 2001 and 2000 have been revised for the disclosure in
Note 2 of the proforma stock-based compensation expense, proforma net loss and
proforma basic and diluted net loss per share that would have been recorded had
the fair value based method of SFAS 123 "Accounting for Stock-Based
Compensation" been adopted for all option grants. Our audit procedures with
respect to the revised disclosures in Note 2 included (i) agreeing the revised
disclosures of proforma stock-based compensation expense, proforma net loss and
proforma basic and diluted net loss per share to the revised underlying
accounting analysis obtained from management, (ii) testing the methods and
assumptions used by management in determining the fair value of option grants
and agreeing the terms of the options granted to underlying supporting
documentation obtained from management and (iii) testing the mathematical
accuracy of the accounting analysis of proforma stock-based compensation
expense, proforma net loss and proforma basic and diluted net loss per share. In
our opinion, such revised disclosures for 2001 and 2000 are appropriate. (c) As
discussed above, the financial statements of the Company for the years ended
December 31, 2001 and 2000 have also been reclassified to give effect to EITF
01-14, which was adopted by the Company on January 1, 2002. We audited the
reclassifications described in Note 2 that were applied to conform the 2001 and
2000 financial statements to the comparative presentation required by EITF
01-14. Our audit procedures with respect to the 2001 and 2000 disclosures in
Note 2 included (i) comparing the amounts shown as Revenue - Reimbursed Expenses
and Cost of Revenues - Reimbursed Expenses in the Company's consolidated
statements of operations to the Company's underlying accounting analysis
obtained from management, (ii) on a test basis, comparing the amounts comprising
Reimbursed Expenses for Revenues and Cost of Revenues obtained from management
to independent supporting documentation, and (iii) testing the mathematical
accuracy of the underlying analysis. In our opinion, such reclassifications have
been properly applied.
However, we were not engaged to audit, review, or apply any procedures to the
2001 and 2000 financial statements of the Company other than with respect to
such disclosures and reclassifications, as mentioned above, and, accordingly, we
do not express an opinion or any form of assurance on the 2001 and 2000
financial statements taken as a whole.
As discussed in Note 2 to the Consolidated Financial Statements, the Company has
changed its method of accounting for goodwill and other intangible assets to
conform to SFAS 142, and as discussed in Note 14 to the consolidated financial
statements, the Company changed its method of accounting for stock-based
compensation to conform to SFAS 123. Both changes were adopted by the Company on
January 1, 2002.
/s/ Deloitte & Touche LLP
New York, New York
February 28, 2003 (except
March 27, 2003, as to the disclosure
of the settlement of a litigation
claim as described in Note 15)
42
THE FOLLOWING REPORTS ARE A COPY OF THE
REPORTS PREVIOUSLY ISSUED BY ARTHUR ANDERSEN LLP AND
HAVE NOT BEEN REISSUED BY ARTHUR ANDERSEN LLP.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Predictive Systems, Inc.:
We have audited the accompanying consolidated balance sheets of
Predictive Systems, Inc. (a Delaware corporation) and subsidiaries as of
December 31, 2001 and 2000, and the related consolidated statements of
operations, stockholders' equity and comprehensive income (loss) and cash flows
for each of the three years in the period ended December 31, 2001. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present
fairly, in all material respects, the financial position of Predictive Systems,
Inc. and subsidiaries as of December 31, 2001 and 2000, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2001 in conformity with accounting principles generally accepted in
the United States.
/s/ ARTHUR ANDERSEN LLP
New York, New York
February 6, 2002
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Predictive Systems, Inc.:
We have audited in accordance with accounting standards generally
accepted in the United States, the financial statements of Predictive Systems,
Inc. included in this filing on Form 10-K and have issued our report thereon
dated February 6, 2002. Our audit was made for the purpose of forming an opinion
on the basic financial statements taken as a whole. The schedule of valuation
and qualifying accounts is the responsibility of the Company's management and is
presented for purposes of complying with the Securities and Exchange
Commission's rules and is not part of the basic financial statements. This
schedule has been subjected to the auditing procedures applied in the audit of
the basic financial statements and, in our opinion, fairly states in all
material respects the financial data required to be set forth therein in
relation to the basic financial statements taken as a whole.
/s/ ARTHUR ANDERSEN LLP
New York, New York
February 6, 2002
43
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
December 31,
----------------------------------
2002 2001
------------- -------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents ................................................................ $ 19,464,669 $ 41,277,867
Restricted cash .......................................................................... 1,364,781 --
Accounts receivable--net of allowance for doubtful accounts of $1,722,078 and
$2,606,361, respectively ............................................................... 3,805,602 10,124,399
Related party receivables ................................................................ 548,704 1,052,540
Unbilled revenues ........................................................................ 1,922,870 1,319,044
Advances under system integrator agreement ............................................... -- 2,205,986
Work in process - hardware and software .................................................. 237,984 --
Receivables from employees and stockholders .............................................. 14,793 61,526
Refundable income taxes .................................................................. 282,913 375,982
Prepaid expenses and other current assets ................................................ 1,654,809 2,180,531
------------- -------------
Total current assets ..................................................................... 29,297,125 58,597,875
Property and equipment--net of accumulated depreciation and amortization of
$722,118 and $4,587,357, respectively .................................................. 306,343 6,323,100
Goodwill - net of accumulated amortization of $2,032,293 and
$19,302,023, respectively .............................................................. 1,669,801 20,841,215
Intangible assets--net of accumulated amortization of
$5,869,293 in 2001 ..................................................................... -- 15,401,707
Restricted cash .......................................................................... 504,000 782,292
Other assets ............................................................................. 432,678 547,103
------------- -------------
Total assets ............................................................................. $ 32,209,947 $ 102,493,292
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable ......................................................................... $ 619,842 $ 5,451,745
Accrued expenses and other current liabilities ........................................... 5,579,670 11,469,090
Deferred revenue ......................................................................... 1,373,691 333,527
Current portion of capital lease obligations ............................................. 48,969 81,714
------------- -------------
Total current liabilities ................................................................ 7,622,172 17,336,076
NONCURRENT LIABILITIES:
Capital lease obligations ................................................................ 8,610 52,134
Deferred rent ............................................................................ 113,344 165,251
Other long-term liabilities .............................................................. -- 3,000
------------- -------------
Total noncurrent liabilities ............................................................. 121,954 220,385
------------- -------------
Total liabilities ........................................................................ 7,744,126 17,556,461
------------- -------------
COMMITMENTS AND CONTINGENCIES (Note 15)
STOCKHOLDERS' EQUITY:
Preferred stock, $.001 par value, 10,000,000 shares authorized,
none issued and outstanding ............................................................ -- --
Common stock, $.001 par value, 200,000,000 shares authorized,
37,633,856 and 36,360,491 shares issued and outstanding, respectively .................. 37,634 36,361
Additional paid-in capital ............................................................... 230,560,837 229,408,586
Deferred compensation .................................................................... (14,238) (182,581)
Accumulated deficit ...................................................................... (206,316,789) (144,390,718)
Accumulated other comprehensive income ................................................... 198,377 65,183
------------- -------------
Total stockholders' equity ............................................................... 24,465,821 84,936,831
------------- -------------
Total liabilities and stockholders' equity ............................................... $ 32,209,947 $ 102,493,292
============= =============
The accompanying notes are an integral part of these
consolidated financial statements.
44
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31,
------------------------------------------------------
2002 2001 2000
------------ ------------- ------------
Revenues:
Professional services............................... $ 44,891,443 $ 66,216,949 $ 85,325,305
Reimbursed expenses................................. 1,253,179 1,872,455 2,920,544
Hardware and software sales......................... 3,815,587 1,990,869 2,949,961
------------ ------------- ------------
Total revenues...................................... 49,960,209 70,080,273 91,195,810
------------ ------------- ------------
Cost of Revenues (excluding noncash charges for
stock-based compensation and services of
$131,376, $102,606 and $58,937, respectively):
Professional services............................... 31,685,260 50,517,538 47,420,520
Reimbursed expenses................................. 1,253,179 1,872,455 2,920,544
Hardware and software............................... 3,418,979 2,090,307 2,200,748
------------ ------------- ------------
Total cost of revenues.............................. 36,357,418 54,480,300 52,541,812
------------ ------------- ------------
Gross profit........................................ 13,602,791 15,599,973 38,653,998
Sales and marketing (excluding noncash charges for
stock-based compensation and services of $49,528,
$35,429 and $64,151, respectively)................ 8,026,827 15,830,308 12,290,414
General and administrative (excluding noncash
charges for stock-based compensation and services
of $148,251, $137,697 and $34,469, respectively).. 20,372,332 42,057,829 32,230,805
Depreciation and amortization....................... 1,707,773 2,872,587 1,657,311
Intangibles amortization............................ 1,960,500 21,932,718 2,911,727
Loss on equipment................................... -- 443,498 --
Impairment of goodwill and intangibles.............. 9,304,995 60,485,448 --
Impairment of property and equipment................ 4,510,193 -- --
Restructuring and other charges..................... 7,468,714 14,672,561 --
Loss on long-term investments in related parties.... -- 2,000,000 --
Noncash charges for stock-based compensation and
services.......................................... 329,155 275,732 157,557
------------ ------------- ------------
Total operating expenses............................ 53,680,489 160,570,681 49,247,814
------------ ------------- ------------
Operating loss...................................... (40,077,698) (144,970,708) (10,593,816)
Other Income (Expense):
Interest income..................................... 411,007 2,565,474 7,260,536
Other income (expense).............................. 1,123,272 (50,819) (268,314)
Interest expense.................................... (34,886) (51,845) (190,519)
------------ ------------- ------------
Loss before income tax provision (benefit) and
cumulative effect of change in accounting
principle......................................... (38,578,305) (142,507,898) (3,792,113)
Income tax provision (benefit)...................... 40,140 (1,634,752) 95,084
------------ ------------- ------------
Loss before cumulative effect of change in
accounting principle.............................. (38,618,445) (140,873,146) (3,887,197)
Cumulative effect of change in accounting principle. (23,307,626) -- --
------------ ------------- ------------
Net loss............................................ $(61,926,071) $(140,873,146) $ (3,887,197)
============ ============= ============
Basic and diluted loss per common share before
cumulative effect of change in accounting
principle......................................... $ (1.03) $ (3.91) $ (0.15)
Cumulative effect of change in accounting principle. (0.63) -- --
------------ ------------- -----------
Basic and diluted net loss per common share ........ $ (1.66) $ (3.91) $ (0.15)
============ ============= ============
Basic and diluted weighted average common shares
outstanding....................................... 37,330,816 36,008,048 26,273,946
============ ============= ============
The accompanying notes are an integral part of these
consolidated financial statements.
45
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS
Common Stock Additional
----------------------- Paid-in
Shares Par Value Capital
---------- ---------- -------------
Balance at January 1, 2000..................................................... 23,429,200 $ 23,429 $ 108,404,681
Comprehensive loss..........................................................
Net loss.................................................................... -- -- --
Unrealized loss on investments.............................................. -- -- --
Foreign currency translation adjustment..................................... -- -- --
Total comprehensive loss....................................................... -- -- --
Issuance of common stock in connection with
Employee Stock Purchase Plan.............................................. 192,723 193 2,571,958
Issuance of common stock in secondary offering,
net of offering expenses of $917,000...................................... 1,000,000 1,000 39,823,079
Issuance of common stock and options in
connection with the acquisition of Synet.................................. 1,922,377 1,923 22,729,425
Issuance of common stock and options in
connection with the acquisition of Global
Integrity................................................................. 5,240,275 5,240 45,057,627
Exercise of options......................................................... 3,119,121 3,119 3,928,871
Income tax benefit relating to
exercise of options....................................................... -- -- 5,238,072
Noncash charges for stock-based compensation
and services.............................................................. -- -- --
---------- -------- -------------
Balance at December 31, 2000................................................... 34,903,696 34,904 227,753,713
Comprehensive loss..........................................................
Net loss.................................................................... -- -- --
Unrealized loss on investments.............................................. -- -- --
Foreign currency translation adjustment..................................... -- -- --
Total comprehensive loss....................................................... -- -- --
Issuance of common stock in connection with
Employee Stock Purchase Plan.............................................. 181,125 181 285,478
Exercise of options......................................................... 1,275,670 1,276 1,567,697
Cancellation of options..................................................... -- -- (281,736)
Noncash charges for stock-based compensation
and services.............................................................. -- -- 83,434
---------- -------- -------------
Balance at December 31, 2001................................................... 36,360,491 36,361 229,408,586
Comprehensive loss..........................................................
Net loss.................................................................... -- -- --
Recognition of foreign currency translation loss on disposition of
Predictive AG............................................................. -- -- --
Foreign currency translation adjustment..................................... -- -- --
Total comprehensive loss....................................................... -- -- --
Issuance of common stock in connection with
Employee Stock Purchase Plan............................................. 77,620 77 62,344
Exercise of options........................................................ 957,650 958 879,333
Cancellation of options.................................................... -- -- (49,729)
Proceeds from sale of common stock to officer.............................. 238,095 238 49,762
Noncash charges for stock-based compensation
and services (Note 14)................................................... -- -- 210,541
---------- -------- -------------
Balance at December 31, 2002.................................................. 37,633,856 $ 37,634 $ 230,560,837
========== ======== =============
The accompanying notes are an integral part of these
consolidated financial statements.
46
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND
COMPREHENSIVE LOSS- (Continued)
Retained Accumulated
Earnings Other Total
Deferred (Accumulated Comprehensive Stockholders'
Compensation Deficit) Income (Loss) Equity
------------ -------- ------------- -------------
Balance at January 1, 2000................................. $ (256,672) $ 369,625 $(39,341) $ 108,501,722
Comprehensive loss......................................
Net loss................................................ -- (3,887,197) -- (3,887,197)
Unrealized loss on investments.......................... -- -- (11,670) (11,670)
Foreign currency translation
adjustment............................................ -- -- 168,532 168,532
------------
Total comprehensive loss................................... (3,730,335)
============
Issuance of common stock in connection
with the Employee Stock Purchase Plan................. -- -- -- 2,572,151
Issuance of common stock in
secondary offering, net of offering
expenses of $917,000.................................. -- -- -- 39,824,079
Issuance of common stock and options
in connection with the acquisition
of Synet.............................................. (474,308) -- -- 22,257,040
Issuance of common stock and options
in connection with the acquisition of
Global Integrity...................................... (120,857) -- -- 44,942,010
Exercise of options..................................... -- -- -- 3,931,990
Income tax benefit relating to
exercise of options................................... -- -- -- 5,238,072
Noncash charges for stock-based compensation
and services.......................................... 157,557 -- -- 157,557
--------- -------------- --------- -------------
Balance at December 31, 2000............................... (694,280) (3,517,572) 117,521 223,694,286
Comprehensive loss......................................
Net loss................................................ -- (140,873,146) -- (140,873,146)
Unrealized loss on investments.......................... -- -- (2,896) (2,896)
Foreign currency translation
adjustment............................................ -- -- (49,442) (49,442)
------------
Total comprehensive loss................................... (140,925,484)
============
Issuance of common stock in connection with
Employee Stock Purchase Plan.......................... -- -- -- 285,659
Exercise of options..................................... -- -- -- 1,568,973
Cancellation of options................................. 319,401 -- -- 37,665
Noncash charges for stock-based compensation
and services.......................................... 192,298 -- -- 275,732
--------- -------------- --------- -------------
Balance at December 31, 2001............................... (182,581) (144,390,718) 65,183 84,936,831
Comprehensive loss......................................
Net loss................................................ -- (61,926,071) -- (61,926,071)
Recognition of foreign currency translation loss on
disposition of Predictive AG.......................... -- -- (139,344) (139,344)
Foreign currency translation
adjustment............................................ -- -- 272,538 272,538
------------
Total comprehensive loss................................... (61,792,877)
============
Issuance of common stock in connection with
Employee Stock Purchase Plan.......................... -- -- -- 62,421
Exercise of options..................................... -- -- -- 880,291
Cancellation of options................................. 49,729 -- -- --
Proceeds from sale of common stock to officer -- -- -- 50,000
Noncash charges for stock-based compensation
and services (Note 14)................................ 118,614 -- -- 329,155
--------- -------------- --------- -------------
Balance at December 31, 2002............................... $ (14,238) $ (206,316,789) $ 198,377 $ 24,465,821
========== =============== ========= =============
The accompanying notes are an integral part of these
consolidated financial statements.
47
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
--------------------------------------------------
2002 2001 2000
------------ ----------- ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss............................................................. $ (61,926,071) $(140,873,146) $ (3,887,197)
Adjustments to reconcile net loss to net cash used in
operating activities--
Noncash charges for stock-based compensation and services.......... 329,155 275,732 157,557
Deferred income taxes.............................................. -- (1,529,498) (462,297)
Depreciation and amortization...................................... 3,668,273 24,805,305 4,569,038
Loss on equipment.................................................. -- 443,498 --
Impairment of goodwill and intangibles............................. 9,304,995 60,485,448 --
Impairment of property and equipment............................... 4,510,193 -- --
Cumulative effect of change in accounting principle................ 23,307,626 -- --
Gain on sale of property and equipment............................. -- -- (3,023)
Bad debt expense................................................... 83,881 4,758,026 4,921,556
Loss on long-term investments in related parties................... -- 2,000,000 --
Impairment of inventory held for resale............................ -- 500,000 --
Write-off of advances under system integrator agreement............ 1,740,236 -- --
Write-off of receivables from employees............................ -- 27,237 --
Non-cash component of restructuring and other charges.............. 655,161 8,118,252 --
(Increase) decrease in--
Restricted cash.................................................... (1,086,489) (782,292) --
Accounts receivable................................................ 5,987,772 6,564,759 (5,655,077)
Related party receivables.......................................... 503,836 3,714,857 (3,840,111)
Unbilled revenues.................................................. (603,826) 2,796,754 (1,740,325)
Advances under system integrator agreement......................... 465,750 (2,205,986) --
Refundable income taxes............................................ 88,724 (375,048) 762,802
Prepaid expenses and other current assets.......................... 250,646 (1,440,703) (300,372)
Other assets....................................................... 114,423 (316,407) 24,833
(Decrease) increase in--
Accounts payable................................................... (4,789,958) 2,392,553 (233)
Accrued expenses and other current liabilities..................... (5,726,907) (3,963,460) 3,673,829
Deferred revenue................................................... 1,040,164 (2,140,033) (665,116)
Deferred rent...................................................... (51,907) (365,338) 480,726
Other long-term liabilities........................................ (3,000) 3,000 (2,498)
------------ ----------- ------------
Net cash used in operating activities................................ (22,137,323) (37,106,490) (1,965,908)
------------ ----------- ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of marketable securities.................................... -- (8,487,989) (8,011,356)
Proceeds from sale or redemption of marketable securities............ -- 12,279,179 6,223,646
Loans to employees................................................... (71,000) (62,576) (76,308)
Repayments from employees for loans.................................. 112,721 111,785 64,647
Settlement of notes receivable, net.................................. -- -- 283,493
Purchases of property and equipment.................................. (911,587) (7,448,973) (6,862,966)
Sale of property and equipment....................................... -- -- 27,500
Net cash paid in acquisitions of Synet and Global Integrity.......... -- -- (43,282,258)
Long-term investment in related parties.............................. -- -- (2,000,000)
------------ ----------- ------------
Net cash used in investing activities................................ (869,866) (3,608,574) (53,633,602)
------------ ----------- ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from sale of common stock to officer........................ 50,000 -- --
Proceeds from public offerings, net of expenses,
including reissuance of treasury stock............................. -- -- 39,824,079
Proceeds from exercise of stock options.............................. 885,301 1,853,774 3,637,436
Proceeds from issuance of common stock in connection
with Employee Stock Purchase Plan.................................. 62,421 285,659 2,572,151
Principal payments on capital leases................................. (76,269) (155,851) (177,531)
------------ ----------- ------------
Net cash provided by financing activities............................ 921,453 1,983,582 45,856,135
------------ ----------- ------------
Effects of exchange rates............................................ 272,538 (49,442) 168,532
Net decrease in cash................................................. (21,813,198) (38,780,924) (9,574,843)
CASH AND CASH EQUIVALENTS, beginning of period....................... 41,277,867 80,058,791 89,633,634
------------ ----------- ------------
CASH AND CASH EQUIVALENTS, end of period............................. $ 19,464,669 $ 41,277,867 $ 80,058,791
============ =========== ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest............................................................. $ 37,208 $ 55,313 $ 190,519
============ =========== ============
Taxes................................................................ $ 219,028 $ 359,744 $ 109,440
============ =========== ============
The accompanying notes are an integral part of these
consolidated financial statements.
48
PREDICTIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS -- (Continued)
Years Ended December 31,
------------------------------------------------
2002 2001 2000
------------- ------------- -------------
DETAILS OF ACQUISITIONS:
Fair value of assets acquired........................ $ -- $ -- $ 127,608,072
Liabilities assumed.................................. -- -- (15,980,009)
Less fair value of equity issued..................... -- -- (67,199,050)
Less accrued transaction expenses.................... -- -- ( 1,133,662)
------------- ------------- -------------
Cash paid.......................................... -- -- 43,295,351
Less cash acquired................................... -- -- (13,093)
------------- ------------- -------------
Net cash paid...................................... $ -- $ -- $ 43,282,258
============= ============= =============
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING
AND FINANCING TRANSACTIONS:
Stock and options issued for acquisition............. $ -- $ -- $ 67,199,050
============= ============= =============
Tax benefits of stock option exercises............... $ -- $ -- $ 5,238,072
============= ============= =============
Services provided to Global Integrity prior to
acquisition date................................... $ -- $ -- $ 555,500
============= ============= =============
Noncash adjustment to purchase price for Fiscal 2000
acquisitions......................................... $ -- $ 2,196,521 $ --
============= ============= =============
The accompanying notes are an integral part of these
consolidated financial statements.
49
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Ownership and Operations:
Predictive Systems, Inc. (the "Company"), was incorporated under the
laws of the State of Delaware on February 10, 1995.
The Company is a leading independent network infrastructure and
security consulting company focused on helping global enterprises and service
providers harness the power of network technology. Specifically, the Company
builds, optimizes, and secures high-performance infrastructures that deliver
measurable results by increasing operational efficiency, mitigating risk, and
empowering its Fortune 1000 clients' business initiatives. The Company's
expertise spans a multitude of disciplines including enterprise management,
performance, network design, and management and information security. Services
are currently provided through the Company's offices and wholly-owned
subsidiaries located throughout the United States and its wholly-owned
subsidiaries in the United Kingdom and The Netherlands. The Company previously
had subsidiaries in Germany, one of which was acquired in the fourth quarter of
2000 through the acquisition of Synet and a second subsidiary which was formed
in the first quarter of 2001, and in Japan, which was also formed in the first
quarter of 2001. During 2002, the two German subsidiaries were merged and in
December 2002, the surviving German subsidiary declared bankruptcy. In July
2002, the Company's Japanese subsidiary was dissolved and liquidated.
(2) Summary of Significant Accounting Policies:
Principles of Consolidation
The consolidated financial statements include the accounts of all
wholly-owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates. Significant accounting estimates used in the preparation of the
Company's consolidated financials statements include the fair value of acquired
assets, purchase price allocations, the fair value of equity instruments
underlying stock-based compensation, the realizability of deferred tax assets,
the carrying value of goodwill and intangible assets, percentage of completion
estimates for fixed price contracts and depreciation and amortization.
Revenue and Cost Recognition
Revenues for time-and-material contracts are recognized as the services
are rendered. Revenue from fixed fee contracts are recognized using the
percentage-of-completion method of accounting, as prescribed by AICPA Statement
of Position 81-1, "Accounting for Performance of Construction-Type and Certain
Production-Type Contracts." The percentage of completion for each contract is
determined based on the ratio of direct labor hours incurred to total estimated
direct labor hours required to complete the contract. The Company may
periodically encounter changes in estimated costs and other factors that may
lead to a change in the estimated profitability of a fixed-price contract. In
such circumstances, adjustments to cost and profitability estimates are made in
the period in which the underlying factors requiring such revisions become
known. If such revisions indicate a loss on a contract, the entire loss is
recorded at such time. Amounts billed in advance of services being performed are
recorded as deferred revenue. Certain fixed-fee contracts may have substantive
customer acceptance provisions. The acceptance terms generally include a single
review and revision cycle for each deliverable to meet the customer's required
performance criteria. Revenue is recognized upon receipt of acceptance from the
customer. The Company acts as a reseller of certain hardware and software.
Revenue is generally recognized when these products are shipped to the customer.
If substantive customer acceptance of the hardware and software is required,
revenue is recognized upon receipt of acceptance from the customer. If the
Company is not the primary obligor in a resale arrangement and receives a stated
percentage of the amount billed to the customer, revenues for the resale of
inventory are recognized on a net basis in the period of resale.
50
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(2) Summary of Significant Accounting Policies: -- (Continued)
The Company on occasion enters into multiple element arrangements under
which it generally provides professional services and hardware and software. The
Company allocates the aggregate revenues from multiple element arrangements to
each element based on objective evidence of the fair value of the elements.
Revenue is recognized as each element is delivered and the Company has no
significant remaining performance obligations. If the Company enters into a
multiple elements agreement where objective evidence of the fair value of each
element of the arrangement does not exist, all revenue from the arrangement is
deferred until all elements of the arrangement are delivered. The Company has
established objective evidence for each of the elements it sells in its multiple
element arrangements as either it or its competitors sell similar professional
services, hardware and software on a standalone basis.
In November 2001, the Emerging Issues Task Force (EITF) of the FASB
issued EITF 01-14 "Income Statement Characterization of Reimbursements Received
for 'Out-of-Pocket' Expenses Incurred" (EITF-01-14). EITF 01-14 requires
reimbursements received for "out-of-pocket" expenses 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 first quarter of 2002. 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.
Unbilled revenues represents costs incurred and estimated earnings,
production, and other client-reimbursable costs. Included in unbilled revenues
as of December 31, 2002 and 2001 is $723,960 and $633,856, respectively, related
to fixed-price contracts.
Deferred revenue represents prepayments from customers for future
services to be performed. Revenue is recognized upon performance of these
related services.
Cash Equivalents
The Company considers all highly liquid investments with a maturity of
three months or less at the time of purchase to be cash equivalents.
Restricted Cash
The Company is required under the terms of certain lease agreements to
provide letters of credit. The credit facility agreement used to provide these
financial guarantees places restrictions on the Company's cash and cash
equivalents. Cash of $1,350,346 (of which $846,346 was classified as current)
and $782,292, respectively, at December 31, 2002 and 2001 was pledged as
collateral under this agreement.
In August 2002, the Company was required under the terms of a customer
contract to provide a letter of credit for the value of services to be
performed. The credit facility agreement used to provide this financial
guarantee places restrictions on the Company's cash and cash equivalents until
the services are rendered to the customer. The services are expected to be fully
rendered by June 30, 2003. Cash of $518,435 as of December 31, 2002 was pledged
as collateral under this agreement and has been recorded in the balance sheet as
a current asset.
Marketable Securities
The Company accounts for marketable securities in accordance with the
provisions of Statement of Financial Accounting Standards No. 115, "Accounting
for Certain Investments in Debt and Equity Securities."
Management determines the appropriate classification of its investments
in equity securities at the time of purchase and reevaluates such determinations
at each balance sheet date. All marketable securities are classified as
available-for-sale and are available to support current operations or take
advantage of other investment opportunities. These securities are stated at
estimated fair value based upon market quotes. Unrealized gains and losses, net
of taxes, are computed on the basis of specific identification and are recorded
as a component of other comprehensive income. Unrealized gains and losses in
fiscal years 2001 and 2000 were immaterial. There were no unrealized gains or
losses in 2002.
51
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(2) Summary of Significant Accounting Policies: -- (Continued)
Advances Under System Integrator Agreement
During 2001, the Company entered into a system integrator agreement
with a vendor under which the Company would solicit orders for the resale of the
vendor's software products. Under the terms of the agreement, the Company is not
the primary obligor in the resale arrangement and receives a stated percentage
of the amount billed to the customer. Revenues are recognized on a net basis in
the period of resale. At December 31, 2001, the carrying value of the system
integrator agreement was $2,205,986. During 2002, the Company received $465,750
of payments from the vendor. The remaining $1,740,236 was written-off in 2002
(Note 17). As the Company was acting as an agent of the supplier in the
arrangement for the resale of this software and the revenues were recognized on
a net basis, such write-off has been classified as restructuring and other
charges.
Property and Equipment
Computer equipment and office furniture are carried at their cost basis
and depreciated using the straight-line method over their estimated useful
lives, ranging from three to five years. Leasehold improvements are amortized
over the lesser of their estimated useful lives or the life of the lease.
Expenditures for maintenance and repairs are charged to operations as incurred
and major expenditures for renewals and asset improvements are capitalized and
depreciated over their useful lives.
The Company capitalizes the costs of acquiring, developing and testing
software to meet the Company's internal needs. Under the provisions of AICPA
Statement of Position 98-1, "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use," the Company capitalizes costs
associated with software developed or obtained for internal use when both the
preliminary project stage is completed and management has authorized further
funding for the project which it deems probable will be completed and used to
perform the function intended. Capitalized costs include only (1) external
direct costs of materials and services consumed in developing or obtaining
internal-use software, (2) payroll and payroll-related costs for employees who
are directly associated with and devote time to the internal-use software
project and (3) interest costs incurred while developing internal-use software.
Capitalization of such costs ceases no later than the point at which the project
is substantially complete and ready for its intended use. Costs associated with
the development of software for internal use have been capitalized in the
amounts of $186,714 and $2,474,656 for the years ended December 31, 2002 and
2001, respectively. Software development costs are amortized using a
straight-line method over a three-year period. Amortization of capitalized
software development costs for internal use software began January 1, 2002, the
date at which the software was ready for its intended use. Such amortization
amounted to $443,491 for the year ended December 31, 2002. During 2002, the
Company recorded an impairment charge for the net book value of capitalized
software costs of $2,217,879 in connection with the impairment review of
long-lived assets in accordance with the provisions of Statement of Financial
Accounting Standards No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets." (Note 8)
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. In accordance with the provisions
of Statement of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets" (SFAS 142), which was adopted by the Company effective
January 1, 2002, the carrying value of goodwill and indefinite lived intangibles
are evaluated for impairment on an annual basis. The Company also reviews
goodwill and indefinite lived intangibles for impairment whenever events or
changes in circumstances indicate that their carrying amount may be impaired. If
the carrying value of goodwill exceeds its implied value an impairment loss is
recognized for an amount equal to the excess of the carrying value over the
implied value. If the carrying amount of an indefinite lived intangible asset
exceeds its fair value, an impairment loss shall be recognized in an amount
equal to that excess. The Company's reporting units utilized for evaluating the
recoverability of goodwill and the indefinite lived intangibles are the same as
its operating segments (Note 7).
Prior to the adoption of SFAS 142 on January 1, 2002, goodwill and
indefinite lived intangibles were amortized on a straight-line basis over
periods from three to five years and were evaluated for impairment under the
provisions of Statement of Financial Accounting Standards No. 121, "Accounting
for the Impairment of Long-Lived Assets to be Disposed Of" (SFAS 121).
Foreign Currency Translation
The financial statements of foreign subsidiaries, where the local
currency is the functional currency, are translated into U.S. dollars using
exchange rates in effect at period end for assets and liabilities and average
rates during each reporting period for results of operations and cash flows.
Adjustments resulting from translation of financial statements are reflected as
a component of other comprehensive income (loss).
52
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(2) Summary of Significant Accounting Policies: -- (Continued)
Income Taxes
The Company accounts for income taxes under Statement of Financial Accounting
Standards No. 109, "Accounting for Income Taxes" (SFAS 109). SFAS 109 requires
the recognition of deferred tax assets and liabilities for the expected future
tax consequences of events that have been included in the financial statements.
Under this method, deferred tax assets and liabilities are determined based on
the differences between the financial statement and the tax bases of assets and
liabilities using enacted tax rates in effect for the year in which the
differences are expected to reverse. A valuation allowance is provided based on
the weight of available evidence, if it is considered more likely than not that
all or some portion of the deferred tax assets will not be realized. (Note 13)
Loss Per Share of Common Stock
The Company calculates its loss per share under the provisions of
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS
128). SFAS 128 requires dual presentation of "basic" and "diluted" loss per
share on the face of the statement of operations. In accordance with SFAS 128,
basic loss per common share is computed by dividing the net loss attributable to
common stockholders by the weighted average number of shares of common stock
outstanding during each period. Diluted loss per share is calculated by dividing
net loss attributable to common stockholders by the weighted average number of
shares of common stock outstanding and all dilutive potential common shares that
were outstanding during the period. The per share effects of potential common
shares such as warrants and options have been excluded from the calculation of
diluted loss per share, as their effect would be antidilutive in all periods
presented.
Accounting for Long-Lived Assets
Long-lived assets consist of property and equipment and other
intangible assets. The Company's other intangible assets are comprised of
amortizable customer lists and developed technology. Long-lived assets are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of the asset may not be recoverable. The Company 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
future undiscounted cash flows expected to result from the use of the asset and
its eventual disposition when indications of impairment are present. If it is
determined that an impairment in value has occurred, the carrying value of the
asset will be reduced to the present value of the expected future operating cash
flows to be generated by the asset (Note 8). The Company adopted the provisions
of Statement of Financial Accounting Standard No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" (SFAS 144) effective January 1,
2002. Prior to the adoption of SFAS 144, the Company accounted for its
long-lived assets in accordance with the provisions of SFAS 121. SFAS 121
established financial accounting and reporting standards for the impairment of
long-lived assets, certain identifiable intangibles, and goodwill related to
those assets to be held and used, and for long-lived assets and certain
identifiable intangibles to be disposed of. SFAS 121 required, among other
things, that an entity review its long-lived assets and certain related
intangibles for impairment whenever changes in circumstances indicate that the
carrying amount of an asset may not be fully recoverable. SFAS 144 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.
Stock-Based Compensation
In October 2002, the Company adopted the fair value provisions of
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS 123). SFAS 123 established a fair-value-based method of
accounting for stock-based compensation plans. Pursuant to the transition
provisions of SFAS 123, the Company is required to apply the fair value method
of accounting to all equity instruments issued to employees on or after
January 1, 2002. The fair value method is not applied to stock option awards
granted in fiscal years prior to 2002. Such awards will continue to be accounted
for under the intrinsic value method pursuant to Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" (APB25), except to
the extent that prior years' awards are modified subsequent to January 1, 2002.
Option grants issued prior to January 1, 2002 that have not been modified or
settled continue to be accounted for under the intrinsic value method of APB 25.
Therefore, the cost related to stock-based employee compensation included in the
determination of the net loss for 2002 is less than that which would have been
recognized if the fair value based method had been applied to all awards since
their date of grant. The following table illustrates the effect on net loss and
net loss per common share if the fair value based method had been applied to all
outstanding and unvested awards in each period.
53
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(2) Summary of Significant Accounting Policies: -- (Continued)
Years Ended December 31,
-------------------------------------------------------
2002 2001 2000
------------- ------------- -------------
Net loss - as reported $ (61,926,071) $(140,873,146) $ (3,887,197)
Add: Stock-based employee
compensation expense included
in reported net loss, net of related
tax effects 329,155 275,732 157,557
Deduct: Total stock-based employee
compensation expense determined
under fair value based method
for all awards, net of related tax effects (6,192,975) (12,147,755) (8,932,844)
------------- ------------- -------------
Net loss - proforma $ (67,789,891) $(152,745,169) $ (12,662,484)
============= ============= =============
Basic and diluted net loss per common share - as
reported $ (1.66) $ (3.91) $ (0.15)
============= ============= =============
Basic and diluted net loss per common share - proforma $ (1.82) $ (4.24) $ (0.48)
============= ============= =============
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, accounts and other
receivables, and accounts payable approximate fair value due to the short-term
maturity of these instruments. The carrying amounts of outstanding capital lease
obligations approximate fair value based on terms and interest rates available
to the Company for similar transactions.
Comprehensive Income (Loss)
The Company reports comprehensive income (loss) in accordance with
Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive
Income" (SFAS 130). SFAS 130 requires that in addition to net income (loss), a
company should report other comprehensive income (loss) consisting of gains and
losses, which bypass the traditional income statement and are recorded directly
into stockholders' equity (deficiency) on the balance sheet. The components of
other comprehensive income for the Company consist of unrealized gains and
losses relating to the translation of financial statements maintained in foreign
currencies and unrealized gains and losses relating to the Company's investments
in marketable securities.
Segment Reporting
Statement of Financial Accounting Standards No. 131, "Disclosures About
Segments of an Enterprise and Related Information" establishes standards for the
way public business enterprises report information about operating segments in
annual financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports issued to
shareholders. The Company has three operating segments consisting of its US
Consulting, International Consulting and Managed Security Services businesses.
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 expense. (Note 16)
54
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(2) Summary of Significant Accounting Policies: -- (Continued)
Recently Issued Accounting Pronouncements
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 consolidated financial position or results of operations.
In April 2002, the FASB issued Statement of Financial Accounting
Standard No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of
FASB Statement No. 13, and Technical Corrections" (SFAS 145). 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 believes that the adoption of this statement will not have a significant
impact on its consolidated financial position or results of operations.
In July 2002, the Financial Accounting Standards Board issued SFAS No.
146, "Accounting for Costs Associated with Exit or Disposal Activities" (SFAS
146). SFAS 146 will supersede EITF 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 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 146 is to be
applied prospectively to exit or disposal activities initiated after December
31, 2002. The Company believes that the adoption of this statement will not have
a significant impact on its consolidated financial position or results of
operations.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness to Others" which elaborates on the disclosures to be
made by a guarantor in its interim and annual financial statements about its
obligations under certain guarantees that it has issued. It also clarifies that
a guarantor is required to recognize, at the inception of a guarantee, a
liability for the fair value of the obligation undertaken in issuing the
guarantee. The initial recognition and measurement provisions of this
Interpretation are applicable on a prospective basis to guarantees issued or
modified after December 31, 2002. The disclosure requirements in this
Interpretation are effective for financial statements of interim or annual
periods ending after December 15, 2002. The Company has provided information
regarding commitments and contingencies relating to guarantees in Note 15.
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure - an amendment of FASB Statement No. 123" (SFAS 148). SFAS 148 amends
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS 123) to provide alternative methods to account for the
transition from the intrinsic value method of recognition of stock-based
employee compensation in accordance with Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" to the fair value recognition
provisions under SFAS 123. The Company adopted the recognition provisions of
SFAS 123 as of January 1, 2002 pursuant to the prospective method of adoption
required by SFAS 123. SFAS 148 provides two additional methods of transition and
will no longer permit the SFAS 123 prospective method to be used for fiscal
years beginning after December 15, 2003. In addition, SFAS 148 amends the
disclosure requirements of SFAS 123 to require prominent disclosure in both
annual and interim financial statements about the method of accounting for
stock-based employee compensation and the proforma effects had the fair value
recognition provisions of SFAS 123 been used for all periods presented. The
Company has adopted the annual disclosure provisions of SFAS 148 in Note 2 to
the consolidated financial statements. The adoption of SFAS 148 will not have a
significant impact on the Company's consolidated results of operations and
financial position.
(3) Acquisitions:
On October 16, 2000, the Company acquired Synet Service Corporation
(Synet) in a transaction accounted for as a purchase. Synet is a network and
systems management consulting firm that works with organizations to improve the
availability and reliability of e-commerce applications and network
infrastructure. The consideration for the acquisition consisted of an aggregate
of 1,922,377 shares of the Company's common stock at a fair value of $11.00 per
share, $9,000,000 cash paid upon closing of the transaction, $1,053,164 cash
paid to fund the operating needs of Synet prior to the closing of the
transaction and transaction expenses of $1,085,417, of which all had been paid
as of December 31, 2001. Approximately 522,000 shares were accounted for as
stock options until a related note was repaid in December 2000, at which time
the shares were considered to be issued for accounting purposes. The Company
also issued options to purchase 242,459 shares of its common stock to employees
of Synet in exchange for their Synet options. These options had a fair value of
$1,110,893 and were accounted for as additional purchase price. The Company
acquired net tangible assets of $1,222,646 and recorded intangible assets of
approximately $33,358,000, which represented customer lists, workforce and the
excess of the purchase price over the fair value of the net tangible assets of
approximately $30,392,000. Additionally, the Company recognized a deferred
income tax liability of $1,184,620 related to the nondeductibility of certain
acquired identifiable intangibles. In 2001, the Company recorded an additional
$498,000 to the purchase price for the closing of certain offices and a
reduction in workforce in connection with the Company's acquisition plan. This
amount consisted of $254,000 for severance benefits for 22 employees and
$244,000 for exit costs related to real estate. Additionally, the Company
recorded an additional reduction to the purchase price of approximately $475,000
as part of the final purchase price allocation. Subsequent to the acquisition
and until the adoption of SFAS 142 on January 1, 2002 (Note 7), goodwill and
indefinite lived intangible assets were being amortized on a straight-line basis
over periods of three to five years. During the years ended December 31, 2001
and 2000, the Company recognized $5,650,998 and $1,325,814, respectively, of
amortization expense related to goodwill and indefinite lived intangible assets
from the acquisition of Synet. The results of operations of Synet have been
included in the results of operations of the Company since the date of
acquisition.
55
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(3) Acquisitions: -- (Continued)
The final purchase price allocation as of October 16, 2001 is as
follows:
Accounts receivable, net ................................... $ 1,342,856
Unbilled revenues .......................................... 599,700
Prepaid expenses and other current assets .................. 823,648
Related party receivable ................................... 487,493
Property and equipment ..................................... 104,872
Goodwill ................................................... 30,414,601
Workforce .................................................. 1,766,000
Customer lists ............................................. 1,200,000
Other assets ............................................... 104,268
Accounts payable ........................................... (540,329)
Accrued expenses and other current liabilities ............. (1,327,807)
Notes payable .............................................. (220,000)
Deferred revenue ........................................... (175,061)
Deferred income tax liability .............................. (1,184,620)
------------
Total purchase price ...................................... $ 33,395,621
============
On December 14, 2000, the Company acquired Global Integrity
Corporation (Global Integrity) in a transaction accounted for as a purchase.
Global Integrity provides information security services to Fortune 500 and
Global 1000 companies. The consideration for the acquisition consisted of an
aggregate of 5,240,275 shares of the Company's common stock at a fair value of
$8.15 per share, $31,460,270 in cash paid at the closing of the transaction and
transaction expenses of $1,830,162. The Company also issued options to purchase
551,048 shares of its common stock to employees of Global Integrity in exchange
for their Global Integrity options. These options had a fair value of $2,271,434
and were accounted for as additional purchase price. Additionally, the Global
Integrity stockholders and optionholders had the right to earn up to an
additional $14,012,500 in value (to be paid in cash to stockholders and
additional options to optionholders) upon the achievement of certain revenue
milestones by the acquired business. The earnout period expired on December 31,
2001 without any payments being made. The Company acquired net tangible assets
of $4,482,032 and recorded intangible assets of approximately $81,096,000, which
represented customer lists, workforce, tradenames, developed technology and the
excess of the purchase price over the fair value of the net tangible assets of
approximately $62,798,000. Additionally, the Company recognized a deferred
income tax liability of $7,308,222 related to the nondeductibility of certain
acquired identifiable intangibles. In 2001, the Company recorded an additional
$3,282,000 to the purchase price for the closing of certain offices and a
reduction in workforce in connection with the Company's acquisition plan. This
amount consisted of $178,000 for severance benefits for 20 employees and
approximately $3,104,000 for exit costs related to real estate. Additionally,
the Company recorded a reduction to the purchase price of approximately $130,000
as part of the final purchase price allocation. Subsequent to the acquisition
and until the adoption of SFAS 142 on January 1, 2002 (Note 7), goodwill and
indefinite lived intangible assets were being amortized on a straight-line basis
over periods of three to five years. During the years ended December 31, 2001
and 2000, the Company recognized $12,014,105 and $524,159, respectively, of
amortization expense related to goodwill and indefinite lived intangible assets
from the acquisition of Global Integrity. The results of operations of Global
Integrity have been included in the results of operations of the Company since
the date of acquisition.
56
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(3) Acquisitions: -- (Continued)
The final purchase price allocation as of December 14, 2001 is as
follows:
Cash and cash equivalents .................................. $ 13,093
Accounts receivable, net ................................... 4,040,788
Unbilled revenues .......................................... 2,277,888
Prepaid expenses and other current assets .................. 1,790,213
Property and equipment ..................................... 1,292,741
Goodwill ................................................... 65,950,551
Workforce .................................................. 2,900,000
Customer lists ............................................. 3,300,000
Developed technology ....................................... 9,575,000
Tradenames ................................................. 2,530,000
Accounts payable ........................................... (197,032)
Accrued expenses and other current liabilities ............. (5,277,987)
Income taxes payable ....................................... (126,680)
Deferred revenue ........................................... (1,898,894)
Deferred income tax liability .............................. (7,899,574)
------------
Total purchase price ................................... $ 78,270,107
============
(4) Net Income (Loss) Per Share:
As discussed in Note 2, 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.
Potential common shares of 9,077,150, 13,327,083 and 10,967,357
representing outstanding options as of December 31, 2002, 2001 and 2000,
respectively, were not considered in the calculation of diluted net loss per
common share for the respective years ended December 31, 2002, 2001 and 2000 as
the effect would be anti-dilutive.
(5) Business Concentrations and Credit Risk:
Financial instruments, which subject the Company to concentrations of
credit risk, consist primarily of cash and cash equivalents and trade accounts
receivable. The Company maintains cash and cash equivalents with various
financial institutions. The Company performs periodic evaluations of the
relative credit standing of these institutions. The Company's clients are
primarily concentrated in the United States. The Company generally does not
require collateral and establishes an allowance for doubtful accounts based upon
factors surrounding the credit risk of customers, historical trends and other
information. For the years ended December 31, 2002, 2001 and 2000, the Company
recorded bad debt expense of approximately $84,000, $4,758,000 and $4,922,000,
respectively. In 2002, the Company wrote-off trade accounts receivable of
approximately $1,002,000. In 2001, the Company wrote-off trade accounts
receivable of approximately $1,925,000 as a result of customers filing for
federal bankruptcy protection, which created significant uncertainty regarding
the Company's ability to collect these outstanding trade accounts receivable
balances. The remaining expense for the year ended December 31, 2001 was
additional provision based on the Company's analysis of its accounts receivable
balances.
57
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(5) Business Concentrations and Credit Risk: -- (Continued)
For the years ended December 31, 2002, 2001 and 2000, approximately 15.0%, 17.3%
and 10.2% of revenues before reimbursed expenses, respectively, were from
BellSouth who is a related party (Note 9). Pfizer accounted for approximately
13.7% of revenues before reimbursed expenses for the year ended December 31,
2002. There were no other customers that accounted for more than 10% of revenues
before reimbursed expenses for the years ended December 31, 2001 and 2000. The
amounts due from BellSouth at December 31, 2002 and 2001 were $524,977 and
$994,322, respectively. For the years ended December 31, 2002, 2001 and 2000,
the Company's five largest customers accounted for approximately 45.4%, 40.6%
and 37.8% of revenues before reimbursed expenses, respectively.
(6) Property and Equipment:
The components of property and equipment at December 31, 2002 and 2001
are as follows:
December 31,
----------------------------
Estimated
Useful
Lives (Yrs) 2002 2001
------------ ------------
Computer equipment ............................. 3 $ 690,201 $ 7,058,766
Office furniture ............................... 5 170,862 829,577
Capitalized software ........................... 3 -- 2,474,656
Leasehold improvements ......................... 5-10 167,398 547,458
------------ ------------
1,028,461 10,910,457
Less: accumulated depreciation and amortization (722,118) (4,587,357)
------------ ------------
$ 306,343 $ 6,323,100
============ ============
Depreciation and amortization expense related to property and
equipment, including property and equipment acquired under capital leases,
aggregated $1,707,773, $2,872,587 and $1,657,311 for the years ending December
31, 2002, 2001 and 2000, respectively. At December 31, 2002, property and
equipment acquired under capital leases had been written-off in its entirety.
(7) Goodwill and Intangible Assets:
On January 1, 2002, the Company adopted the provisions of Statement of
Financial Accounting Standards No. 141, "Business Combinations" (SFAS 141) and
Statement of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets" (SFAS 142). SFAS 141 requires that all business combinations
subsequent to June 30, 2001 be accounted for under the purchase method of
accounting. SFAS 141 also requires that the fair value of an assembled workforce
acquired be included in the amount initially recorded as goodwill. Upon adoption
of SFAS 141, the Company reclassified $2,947,748 into goodwill which was
initially recorded as other intangible assets related to the value of the
assembled workforces of Synet and Global Integrity. SFAS 142 requires that upon
adoption, amortization of goodwill and indefinite lived intangible assets cease,
and instead, the carrying value of goodwill and indefinite lived intangible
assets be evaluated for impairment on at least an annual basis. SFAS 142 also
requires the goodwill of each reporting unit to be tested for impairment as of
the beginning of the fiscal year in which this statement is initially applied.
The Company's reporting units utilized for evaluating the recoverability of
goodwill are the same as its operating segments. The Company evaluated goodwill
and its tradename intangible asset for impairment as of January 1, 2002 and
determined that an impairment of $23,307,626 existed at that date. This
impairment charge has been reflected as a cumulative effect of a change in
accounting principle in the consolidated statement of operations for the year
ended December 31, 2002. An independent third party valuation specialist using a
combined income and market approach determined the fair value of the Company's
reporting units. The impairment charge resulted from a continued decline in the
Company's revenues and a reduction in the expected future cash flows to be
generated from operations.
58
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(7) Goodwill and Intangible Assets: -- (Continued)
Due to revenue declines in the Synet and Global Integrity businesses
during 2001 compared to prior periods and forecasted earnings, and the overall
deterioration of market conditions in the enterprise sector, the Company
reviewed goodwill and the intangible assets for impairment during the third
quarter of 2001. As a result of this review, an impairment loss of $18,174,755
and $42,310,693, respectively, was recognized for the year ended December 31,
2001 for the difference between the estimated fair value of Synet and Global
Integrity based on the discounted expected future cash flows and the carrying
amount of their assets and liabilities, including goodwill and intangible
assets.
The following table reports the amounts that loss and basic and diluted
loss per common share before the cumulative effect of the change in accounting
principle would have been in all periods presented, exclusive of the
amortization of goodwill and indefinite lived intangibles recognized in those
periods.
Years Ended December 31,
-----------------------------------------------------
2002 2001 2000
--------------- --------------- ---------------
Reported loss before cumulative effect
of change in accounting principle $ (38,618,445) $ (140,873,146) $ (3,887,197)
Goodwill amortization -- 16,456,303 2,518,849
Assembled workforce amortization -- 1,555,474 162,778
Tradename amortization -- 506,026 21,058
--------------- --------------- ---------------
Adjusted loss before cumulative effect
of change in accounting principle $ (38,618,445) $ (122,355,343) $ (1,184,512)
=============== =============== ===============
Reported basic and diluted loss per
common share before cumulative effect
of change in accounting principle $ (1.03) $ (3.91) $ (0.15)
Goodwill amortization -- 0.46 0.09
Assembled workforce amortization -- 0.04 0.01
Tradenames amortization -- 0.01 --
--------------- --------------- ---------------
Adjusted basic and diluted loss per
common share before cumulative effect
of change in accounting principle $ (1.03) $ (3.40) $ (0.05)
=============== =============== ===============
In December 2002, the Company's German subsidiary, which is included in
its International Consulting reporting unit, filed for bankruptcy. The
provisions of SFAS 142 required that the Company review goodwill associated with
its International Consulting reporting unit for impairment as a result of the
bankruptcy filing. Based on this review, the Company determined that an
impairment of $561,450 existed at December 31, 2002 related to the goodwill of
the International Consulting reporting unit. The fair value of the Company's
International Consulting reporting unit was determined by an independent third
party valuation specialist using a combined income and market approach.
59
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(7) Goodwill and Intangible Assets: -- (Continued)
Changes in the carrying amount of goodwill for the years ended
December 31, 2002 and 2001, by operating segment, are as follows:
International
US Consulting Managed Services Consulting
------------- ---------------- -------------
Balance as of January 1, 2001 $ 57,845,348 $ 33,640,741 $ 3,083,959
Amortization expense (9,911,313) (5,692,282) (852,708)
Purchase price adjustments 1,490,367 1,722,551 --
Impairment of goodwill and intangibles (37,637,674) (22,847,774) --
------------ ------------ ------------
Balance as of December 31, 2001 11,786,728 6,823,236 2,231,251
Reclassification of assembled workforce 2,285,180 662,568 --
Cumulative effect of change in accounting
principle (14,071,908) (7,485,804) --
Impairment of goodwill and intangibles -- -- (561,450)
------------ ------------ ------------
Balance as of December 31, 2002 $ -- $ -- $ 1,669,801
============ ============ ============
At December 31, 2002 and 2001, the Company's intangible assets and
related accumulated amortization consisted of the following:
December 31,
--------------------------------------------------------------------------------
2002 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 (1,994,789) 7,580,211
Assembled workforce -- -- -- 4,666,000 (1,718,252) 2,947,748
----------- ----------- ----------- ----------- ----------- -----------
Total -- -- -- 18,741,000 (5,342,209) 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 $(5,869,293) $15,401,707
=========== =========== =========== =========== =========== ===========
During the year ended December 31, 2002, the Company recorded
impairment charges of $8,743,545 related to amortized intangible assets (Note
8).
60
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(7) Goodwill and Intangible Assets: -- (Continued)
The aggregate amortization expense for intangible assets was
$1,960,500, $5,476,415 and $392,878 for the years ended December 31, 2002, 2001
and 2000, respectively. As of December 31, 2002, the Company had no intangible
assets subject to amortization.
(8) Impairment of Long-Lived Assets:
As a result of the Company's operating performance, 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 during June of 2002. An
impairment loss is recognized if the carrying amount of a long-lived asset group
is not recoverable. 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
loss 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 finite lived intangible assets and other
long-lived assets for the US Consulting and Managed Security Services reporting
units, it was determined by an independent third party valuation specialist that
the carrying values of these assets were not recoverable. As a result, the
Company recorded an impairment charge during 2002 related to finite lived
intangibles and property and equipment of $8,743,545 and $4,510,193,
respectively. The fair values of the asset groups were determined based on the
discounted cash flows expected 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 year ended
December 31, 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
========== ========== ==========
(9) Related Parties:
In June 2002 the Company entered into a consulting agreement with Meyer
Capital Partners LLC to assist management of the Company in the analysis,
valuation and screening process of potential merger and/or acquisition
opportunities. A director of the Company is the managing member of Meyer Capital
Partners LLC. In 2002, the Company granted Meyer Capital Partners LLC 50,000
options pursuant to the terms of the consulting agreement. The fair value of
these options has been recorded as consulting expense during 2002. For the year
ended December 31, 2002, the Company recognized expense of $62,591 for such
services. As of December 31, 2002, the amount due to Meyer Capital Partners LLC
was $10,000. Such amount is included in accrued expenses and other current
liabilities.
The Company provides network consulting services to Cisco Systems, Inc.
("Cisco") pursuant to a consulting services 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 years ended December 31, 2002, 2001 and 2000, the Company
recognized revenues of approximately $28,000, $698,000, and $4.3 million,
respectively, from services performed for Cisco. As of December 31, 2002,
amounts due from Cisco were $447. There were no amounts due from Cisco as of
December 31, 2001.
61
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(9) Related Parties: -- (Continued)
The Company provides network consulting services to BellSouth
Corporation ("BellSouth") pursuant to a consulting services agreement. One of
the Company's directors is also an officer of BellSouth. For the years ended
December 31, 2002, 2001 and 2000, the Company recognized revenues of
approximately $7,300,000, $11,800,000 and $9,000,000, respectively, from
services performed for BellSouth. As of December 31, 2002 and 2001, amounts due
from BellSouth were $524,977 and $994,322, respectively. Such amounts are
included in related party receivables.
The Company provided network consulting services to mFormation Technologies Inc.
("mFormation") pursuant to a consulting services agreement. One of the Company's
former directors was also an officer of mFormation. For the year ended
December 31, 2001, the Company recognized revenues of approximately $13,000.
There were no revenues recognized from services performed for mFormation for the
years ended December 31, 2002 and 2000. There were no amounts due from
mFormation as of December 31, 2002. As of December 31, 2001, $7,875 was due from
mFormation. Such amount is included in related party receivables.
The Company provided network consulting services to Riversoft PLC
pursuant to a consulting services 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 Company's directors is also a general
partner for a venture capital firm, which owned approximately 10% of Riversoft
PLC. In 2002, Riversoft PLC was sold in an all cash transaction. For the years
ended December 31, 2001 and 2000, the Company recognized revenues of
approximately $70,000 and $651,000, respectively, from services performed for
Riversoft PLC. No services were performed for Riversoft PLC during 2002. As of
December 31, 2001, amounts due from Riversoft PLC were $50,343. Such amount is
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 years ended December 31, 2002 and 2001, revenues
from SAIC were approximately $153,000 and $245,000, respectively. There were no
revenues from SAIC during 2000. For the years ended December 31, 2002 and 2001,
the Company purchased approximately $4,000 and $195,000, respectively, in
consulting services from SAIC. There were no amounts purchased from SAIC during
2000. Additionally, SAIC provided the Company with various services relating to
alarm, telecommunications and IT support functions and the Company rented
certain of its office space from SAIC. For the years ended December 31, 2002 and
2001, the Company paid approximately $1,124,000 and $1,440,000, respectively,
for such services and the rental of office space including the buyout of the
real estate lease in August 2002. There were no amounts paid during 2000. Of the
amounts paid for the years ended December 31, 2002 and 2001, approximately
$136,000 and $1,077,000, respectively was expensed. The remaining amounts paid
were accrued in 2001 in connection with our acquisition plan. In addition, the
Company and SAIC license certain of their respective intellectual property to
the other. As of December 31, 2002, $23,280 was due from SAIC. Such amount is
included in related party receivables. There were no amounts due from SAIC as of
December 31, 2001. As of December 31, 2001, $236,130 was owed to SAIC. As of
December 31, 2002 there were no amounts owed to SAIC.
On December 22, 2000, the Company purchased a $1,000,000 12%
Convertible Promissory Note (the "Note") issued by 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 $1,000,000 on its investment for the
year ended December 31, 2001. During 2000, the Company recorded revenues of
$350,750 from services performed for Paradigm4. The Company did not recognize
any revenues from Paradigm4 for the years ended December 31, 2002 and 2001.
On October 6, 2000, the Company purchased 1,000,000 shares of Series A
Preferred Stock in Three Pillars, which the Company had recorded as a long-term
investment in related party. At the time of the investment, Three Pillars had
3,800,000 shares of Series A Preferred Stock and 8,100,000 shares of common
stock outstanding, giving the Company an 8.4% interest on an as converted basis.
The Series A Preferred Stock had certain antidilution rights, but converted
initially on a one for one basis into common stock. The Series A Preferred Stock
had a liquidation preference equal to $1.00 per share plus a 10% cumulative
dividend. The Company also received certain registration rights with respect to
the shares purchased. During 2001, the Company recognized a loss on its
$1,000,000 investment in Three Pillars due to management's determination that
the value of the investment was impaired. During 2000, the Company recorded
revenues of $337,530 from services performed for Three Pillars. The Company did
not recognize any revenues from Three Pillars for the years ended December 31,
2002 and 2001.
62
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(9) Related Parties: -- (Continued)
Receivables from employees and stockholders represent short-term loans
to such parties entered into in the normal course of business.
(10) Accrued Expenses and Other Current Liabilities:
Accrued expenses and other current liabilities for the years ended
December 31, 2002 and 2001 were as follows:
December 31,
--------------------------
2002 2001
----------- -----------
Accrued compensation ............................ $ 893,012 $ 3,617,763
Restructuring accrual ........................... 2,513,767 1,855,540
Synet and Global Integrity acquisition accruals.. -- 2,246,296
Other ........................................... 2,172,891 3,749,491
----------- -----------
$ 5,579,670 $11,469,090
=========== ===========
(11) Credit Facility:
On August 31, 1998, the Company entered into a loan facility, secured
by a lien on all of the Company's assets, under which the Company could borrow
up to the lesser of $5,000,000 or 80.0% of accounts receivable. Termination of
such loan facility would occur on demand. The demand loan facility was
terminated in December 2002. Interest on amounts outstanding under the facility
was based on the lender's base rate plus one percent and was payable on the last
day of each month. The interest rate was 4.75% as of December 31, 2001. There
were no interest charges for the year ended December 31, 2002, 2001 and 2000.
The amount available under the loan facility as of December 31, 2001 was
$5,000,000. The facility contained various financial and other covenants and
conditions. The Company complied with all covenants and conditions as of
December 31, 2001.
(12) Capital Lease Obligations:
The Company has entered into various leases for computer equipment,
office furniture, and leasehold improvements. These leases have been capitalized
using interest rates ranging from 7.88% to 18.83% and expire on various dates
through 2004. Depreciation on the capitalized assets acquired pursuant to
capital leases has been included in depreciation and amortization expense in the
accompanying statements of operations.
The future minimum lease payments required under the above mentioned
capital leases for the twelve months ended December 31, are as follows:
Year
----
2003................................................ $ 58,909
2004................................................ 8,610
Less -- Amount representing interest................ (9,940)
---------
Present value of net minimum lease payments......... 57,579
Less -- Current portion............................. (48,969)
---------
Capital lease obligations - long-term............... $ 8,610
=========
63
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(13) Income Taxes:
The components of the Company's provision (benefit) for income taxes
for the years ended December 31, 2002, 2001 and 2000 are as follows:
Years Ended December 31,
-----------------------------------------------
2002 2001 2000
--------- ---------- ---------
Current income tax provision (benefit):
Federal.................................................. $ -- $ -- $ 42,950
State.................................................... 40,140 -- 459,807
Foreign.................................................. -- (105,254) 54,624
--------- ----------- ----------
40,140 (105,254) 557,381
Deferred income tax benefit:
Federal.................................................. -- (997,566) (356,081)
State.................................................... -- (531,932) (106,216)
--------- ------------ ----------
-- (1,529,498) (462,297)
--------- ------------ ----------
Total income tax provision (benefit)..................... $ 40,140 $(1,634,752) $ 95,084
========= ============ ==========
The following table indicates the significant elements contributing to
the difference between the Federal statutory rate and the Company's effective
tax rate:
Years Ended December 31,
-------------------------------
2002 2001 2000
---- ---- ----
Federal statutory rate..................................... (34.0)% (34.0)% (34.0)%
State taxes, net of Federal effect......................... (3.8) (0.2) 6.2
Non-deductible goodwill amortization....................... -- 3.9 22.6
Impairment of goodwill..................................... 10.5 14.4 --
Meals and entertainment.................................... 0.1 0.1 3.1
Reversal of income tax receivable.......................... -- -- 6.3
Valuation allowance........................................ 22.3 14.8 --
Foreign rate differential and NOL adjustment............... 3.4 -- --
Other...................................................... 1.6 (0.1) (1.7)
----- ----- -----
0.1% (1.1)% 2.5%
===== ===== ======
64
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(13) Income Taxes: -- (Continued)
Effective October 16, 2000, Synet converted from a cash basis to an
accrual basis taxpayer as of the acquisition date. The conversion from the cash
basis to accrual basis required the recognition of a deferred tax asset of
approximately $76,000, which was recognized as an acquired asset. Other major
components of the deferred tax assets and (liabilities) as of December 31, 2002
and 2001 are as follows:
December 31,
-------------------------------
2002 2001
----------- ------------
Intangibles............................................ $ -- $ (6,211,416)
Bad debt reserve....................................... 607,914 843,838
Depreciation........................................... 751,837 (121,591)
Change from cash to accrual basis liability............ 19,474 38,072
Deferred rent.......................................... 45,172 66,645
Accrued vacation....................................... -- 99,059
Other accrued expenses................................. 50,297 1,530,772
Net operating loss carryforwards....................... 60,487,885 51,469,973
Other, net............................................. 139,452 560,252
----------- ------------
Subtotal 62,102,031 48,275,604
Valuation allowance.................................... (62,102,031) (48,275,604)
----------- ------------
Total deferred income tax asset........................ $ -- $ --
=========== ============
The Company has provided a valuation allowance equal to 100% of its net
deferred tax asset due to the uncertainty of generating future profits that
would allow for the realization of such deferred tax asset. The net increase in
the total valuation allowance for the year ended December 31, 2002 was
$13,826,427.
At December 31, 2002 the Company had available net operating loss
carryforwards of approximately $151,000,000 to reduce future period's taxable
income. There may be some limitations on the annual utilization of these net
operating loss carryforwards under the ownership change rules of section 382 of
the Internal Revenue Code. These loss carryforwards begin to expire in 2018.
Included in the net operating loss carryforward at December 31, 2002 is
approximately $68,100,000 related to the exercise of nonqualified stock options
and disqualifying dispositions. Valuation allowances were recorded in 2002 and
2001 for approximately $900,000 and $4,000,000, respectively, related to stock
option compensation that, tax effected, will be credited to equity upon
utilization of tax carryforwards.
At December 31, 2002, the Company's subsidiaries in England and The
Netherlands had available net operating losses of approximately $8,100,000 in
total, the tax benefits of which have been reserved for by a valuation allowance
because of the uncertainty of their realizability.
(14) Stockholders' Equity:
Preferred Stock
The Company is authorized to issue up to an aggregate of 10,000,000
shares of preferred stock, $0.001 par value per share (the "Preferred Stock"),
with such voting rights as may be determined by the Board of Directors. The
Company does not have current plans to issue any shares of Preferred Stock.
Common Stock
The Company has one class of voting securities outstanding, its common
stock, $0.001 par value per share (the "Common Stock"). Each holder of Common
Stock is entitled to one vote for each share held.
On April 5, 2000, the Company consummated a follow-on public offering
for 3,800,000 shares of its common stock at an offering price of $43.00 per
share, of which 1,000,000 shares were sold by the Company, while the remainder
were sold by certain stockholders, resulting in net proceeds to the Company of
approximately $39.8 million after deducting underwriter discounts, commissions
and other offering expenses payable by the Company.
65
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(14) Stockholders' Equity: -- (Continued)
On October 16, 2000, in connection with the acquisition of Synet the
Company issued 1,922,377 shares of common stock which were valued at $11.00 per
share less 521,765 shares which were accounted for as stock options until a
related note was repaid in December 2000, at which time the shares were issued.
On December 14, 2000, in connection with the acquisition of Global
Integrity the Company issued 5,240,275 shares of common stock which were valued
at $8.15 per share.
On September 30, 2002, the Company sold and issued 238,095 shares of
common stock at a price of $0.21 per share, the fair market value of the common
stock at the date of sale, to an officer of the Company.
Stock Options
In 1998, the Company adopted its Stock Option/Stock Issuance Plan (the
Option Plan). Prior to this time, options were not issued in connection with any
plan. The Option Plan is divided into two separate equity programs, the Option
Grant Program and the Stock Issuance Program. Under the Option Grant Program,
the Company may issue incentive stock options and nonqualified stock options.
Under the Stock Issuance Program the Company may issue shares of common stock
either through the purchase of such shares or as a bonus for services rendered.
To date, no shares have been issued under the Stock Issuance Program. Awards
under either program may be granted to such directors, employees and consultants
of the Company as the Board of Directors selects in its discretion.
The 1999 Stock Incentive Plan (the 1999 Plan), adopted and effective on
September 14, 1999, is intended to serve as the successor equity incentive
program to the Option Plan. At December 31, 2002, the Company has authorized
21,378,240 shares of common stock for issuance under the 1999 Plan. The share
reserve automatically increases on the first trading day of January each
calendar year, beginning in January 2001, by a number of shares equal to 1% of
the total number of shares of common stock outstanding on the last trading day
of the immediately preceding calendar year, but no such annual increase will
exceed 500,000 shares. Prior to December 2002, no participant in the 1999 Plan
could receive option grants or direct stock issuances for more than 500,000
shares in the aggregate in any calendar year. On December 10, 2002, the 1999
Plan was amended to increase the maximum number of option grants or direct stock
issuances a participant may receive to 2,000,000 shares in the aggregate in any
calendar year. On January 1, 2002 and 2001, the share reserve was increased by
363,604 and 349,036 shares, respectively. As of December 31, 2002, 12,441,971
shares were available under the 1999 Plan for grant.
Outstanding options under the Option Plan were incorporated into the
1999 Plan upon the date of the Company's initial public offering, and no further
option grants may be made under the Option Plan. The incorporated options will
continue to be governed by their existing terms, unless the Company extends one
or more features of the 1999 Plan to those options.
The Employee Stock Purchase Plan (the Employee Plan) was adopted and
approved by the Company on September 14, 1999. The plan, effective on October
27, 1999, is designed to allow eligible employees, as defined, to purchase
shares of common stock, at semi-annual intervals, through periodic payroll
deductions. On December 10, 2002, the Employee Plan was amended to increase the
number of shares reserved for issuance thereunder for a total number of shares
authorized for issuance under the Employee Plan of 1,150,000 shares. As of
December 31, 2002 and 2001, 451,468 and 373,848 shares, respectively, were
issued in connection with the Employee Plan.
The Employee Plan has a series of successive offering periods, each
with a maximum duration of 24 months. The current offering period began on the
last business day of October 2002 and will end on the last business day of
October 2004. The Employee Plan will terminate no later than the last business
day in October 2009.
Individuals who are eligible employees on the start date of any
offering period may enter the Employee Plan on that start date or on any
subsequent semi-annual entry date (generally May 1 or November 1 each year).
Individuals who become eligible employees after the start date of the offering
period may join the Employee Plan on any subsequent semi-annual entry date
within that period. A participant may contribute up to 10% of his or her
earnings through payroll deductions and the accumulated payroll deductions will
be applied to the purchase of shares on the participant's behalf on each
semi-annual purchase date (the last business day in April and October each
year). The purchase price per share will be 85% of the lower of the fair market
value of the common stock on the participant's entry date into the offering
period or the fair market value on the semi-annual purchase date. The first
purchase date occurred the last business day in April 2000. In no event,
however, may any participant purchase more than 500 shares, nor may all
participants in the aggregate purchase more than 187,500 shares on any one
semi-annual purchase date. Should the fair market value of the common stock on
any semi-annual purchase date be less than the fair market value on the first
day of the offering period, then the current offering period will automatically
end and a new offering period will begin, based on the lower fair market value.
66
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(14) Stockholders' Equity: -- (Continued)
In October 2002, the Company implemented a voluntary stock option
exchange program whereby the Company offered to exchange certain outstanding
options to purchase shares of the Company's common stock held by eligible
employees of the Company, with exercise prices per share greater than or equal
to $0.80, for new options to purchase shares of the Company's common stock (the
"Offer to Exchange"). Under the terms of the Offer to Exchange, the 193
participating employees had certain of their existing options to purchase
4,085,860 shares of the Company's common stock cancelled as of October 18, 2002
and received options to purchase 3,139,424 shares of the Company's common stock
with an exercise price equal to the closing market price of $0.22 per share on
October 18, 2002. All new options were granted under the 1999 Stock Incentive
Plan, as amended. Each new option vests in equal monthly installments in
accordance with a four year vesting schedule beginning on the date of grant.
However, the vesting period was accelerated based on years of service with the
Company measured as of the date of grant. Employees holding over 500,000
options, the maximum number of options that may be issued per year to a single
employee pursuant to the Company's 1999 Stock Incentive Plan, were only
permitted to receive up to 500,000 new options pursuant to the Offer to
Exchange. The Company also re-priced 1,500,000 of its Chief Executive Officer's
outstanding options to give these options the same terms as if he had been able
to fully participate in the Offer to Exchange.
A summary of the Company's stock option activity is as follows:
Years Ended December 31,
-----------------------------------------------------------------------------
2002 2001 2000
-------------------- ---------------------- --------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
------ ----- ------ ----- ------ -----
Outstanding at beginning of
period.......................... 13,327,083 $5.46 10,967,357 $ 8.44 10,756,910 $ 3.11
Granted......................... 8,847,467 0.29 8,984,824 3.02 4,421,735 18.63
Exercised....................... (957,650) 0.90 (1,275,670) 1.23 (3,119,121) 1.26
Forfeited....................... (12,139,750) 5.49 (5,349,428) 8.10 (1,092,167) 17.70
----------- ----- ---------- ------ ---------- ------
Outstanding at end of period 9,077,150 $0.82 13,327,083 $ 5.46 10,967,357 $ 8.44
=========== ===== ========== ====== ========== ======
Options exercisable at end of
period........................ 1,955,170 $2.18 5,028,509 $ 5.02 4,112,602 $ 2.68
=========== ===== ========== ====== ========== ======
Weighted average fair value of
options granted during period $0.19 $1.54 $ 11.42
The following table summarizes information about stock options
outstanding at December 31, 2002:
Total Weighted Weighted Options
Outstanding at Average Average Exercisable at Weighted
Range of Exercise December 31, Exercise Contractual December 31, Average
Prices 2002 Price Life (in yrs) 2002 Exercise Price
-------------------------------------------------------------------------------------------------
$0.19 - $0.26 8,002,868 $ 0.22 9.17 1,269,866 $ 0.22
0.31 - 0.50 224,000 0.42 9.96 11,575 0.50
0.83 - 1.25 205,480 1.16 5.63 159,976 1.22
1.28 - 1.60 37,051 1.54 7.05 32,634 1.55
1.96 - 2.92 291,037 2.58 5.77 229,539 2.53
3.15 - 4.09 159,170 3.94 4.36 143,198 3.93
6.50 - 8.81 14,354 7.50 7.27 8,299 7.47
10.20 - 15.00 40,608 10.86 6.68 29,144 10.89
16.07 - 22.00 43,250 18.94 5.92 33,217 18.77
29.06 - 35.94 23,291 32.01 6.24 16,953 31.60
45.06 - 65.50 36,041 49.59 4.49 20,769 50.59
------------- -------------------------------
9,077,150 8.85 1,955,170
67
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(14) Stockholders' Equity: -- (Continued)
Prior to January 1, 2002, the Company accounted for its employee stock
options under the intrinsic value method of APB Opinion No. 25, "Accounting for
Stock Issued to Employees," and related interpretations. No stock-based employee
compensation expense is reflected in the statement of operations for options
granted to employees to purchase common stock granted with an exercise price
equal to the market value of the underlying common stock on the date of grant.
Effective January 1, 2002, the Company adopted the fair value recognition
provisions of FASB Statement No. 123, "Accounting for Stock-Based Compensation."
The fair value method has been applied prospectively to all employee awards
granted, modified, or settled after January 1, 2002. Option grants issued prior
to January 1, 2002 that have not been modified or settled continue to be
accounted for under the intrinsic value method of APB 25. Certain options
granted prior to January 1, 2002 that were subject to the option exchange offer,
but whose holders elected not to participate in the exchange program, will
be subject to variable accounting under APB 25. Employee awards vest over
periods of four years. In the fourth quarter of 2002, the Company recorded
$210,541 for noncash charges for stock-based compensation and services as a
result of the adoption of SFAS 123. The Company issued a limited number of stock
options prior to October 1, 2002 for which the charge was taken in the fourth
quarter of 2002. The impact of applying the fair value provisions of SFAS 123 to
options granted during 2002 prior to October 1, 2002 was de minimus and
therefore the Company has not restated its previously reported interim results
for the fiscal 2002 quarters ended March 31, 2002, June 30, 2002 and September
30, 2002.
The fair value of all option grants is estimated on the date of grant
using the Black-Scholes model with the following weighted-average assumptions
used for grants in 2002, 2001 and 2000:
o weighted-average risk free interest rates of 2.39%, 4.44% and
5.70%, respectively;
o expected dividend yields of 0%;
o expected lives of 2.5 years; and
o expected volatility of approximately 126%, 126% and 111%,
respectively.
Deferred Compensation
During 1999, the Company granted stock options with exercise prices
which were less than the fair market value of the underlying shares of common
stock at the date of grant. As a result, the Company recorded deferred
compensation of $304,625. In connection with the acquisition of Synet and
Global, the Company granted stock options to employees of Synet and Global which
had exercise prices that were less than the fair market value of the underlying
shares of common stock at the date of grant. As a result, the Company recorded
deferred compensation of $474,308 and $120,857, respectively. These amounts were
to be recognized as noncash compensation expense over the vesting period of the
options (approximately 4 years). During 2002, the Company adjusted deferred
compensation for $49,731 for options which had been cancelled during the year.
For the years ended December 31, 2002, 2001 and 2000, $118,614, $275,732 and
$157,557, respectively, of the deferred compensation was amortized to expense
and has been reflected as noncash compensation expense in the accompanying
statements of operations.
(15) Commitments And Contingencies:
Operating Leases
The Company leases office space and equipment under various
non-cancelable operating leases with initial terms ranging from approximately
one month to ten years, with an option to renew certain leases for an additional
five years. These leases provide for minimum annual lease payments and
additional operating expense charges.
The future minimum lease payments required under the non-cancelable
operating leases as of December 31, 2002 are as follows:
Year
2003............................................. $1,994,488
2004............................................. 1,574,859
2005............................................. 1,084,401
2006............................................. 900,411
2007............................................. 783,708
2008 and thereafter.............................. 2,351,124
----------
Total minimum lease payments..................... $8,688,991
==========
68
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(15) Commitments And Contingencies: -- (Continued)
Rent expense for office space was $3,235,651, $4,172,348 and $2,421,069
for the years ended December 31, 2002, 2001 and 2000, respectively. Equipment
lease expense was $1,345,757, $1,731,849, and $1,511,741 for the years ended
December 31, 2002, 2001 and 2000, respectively.
Benefit Plan
The Company has a 401(k) Plan (the "Plan") to provide retirement
benefits for its employees. As allowed under Section 401(k) of the Internal
Revenue Code, the Plan provides tax-deferred salary deductions for eligible
employees.
As of December 31, 2002, employees could contribute up to 15% of their
annual compensation, as defined by the Plan, and are limited each year to a
maximum annual amount as set periodically by the Internal Revenue Service. The
Company may provide discretionary contributions to the plan. The Company did not
make any contributions to the Plan during the years ended December 31, 2002,
2001 or 2000. Company contributions are subject to certain Internal Revenue Code
limitations. Participants may also contribute amounts representing distributions
from other qualified plans of a previous employer.
Employment Agreements
The Company has entered into employment agreements with certain
executives of the Company. The employment agreements have various expiration
dates through November 2005, and automatically renew unless either party gives
notice of termination. Commitments under these agreements provide for annual
payments of approximately $1.5 million, $1.2 million and $830,000 for fiscal
years 2003, 2004 and 2005, respectively.
Guarantees
In the normal course of business, the Company enters into contracts in
which it makes representations and warranties regarding the performance of its
services and that its services will not infringe on third party intellectual
property rights. Historically, there have been no significant losses related to
such representations and warranties and the Company expects these losses to be
minimal in the future.
The Company is required under the terms of certain lease agreements to
provide letters of credit. The credit facility agreement used to provide these
financial guarantees places restrictions on the Company's cash and cash
equivalents. Cash of $1,350,346 (of which $846,346 was classified as current)
and $782,292, respectively, at December 31, 2002 and 2001 was pledged as
collateral under this agreement. In August 2002, the Company was required under
the terms of a customer contract to provide a letter of credit for the value of
services to be performed. The credit facility agreement used to provide this
financial guarantee places restrictions on the Company's cash and cash
equivalents until the services are rendered to the customer. The services are
expected to be fully rendered by June 30, 2003. Cash of $518,435 as of
December 31, 2002 was pledged as collateral under this agreement.
Litigation
Except as set forth below, the Company is not a party to any material
legal proceedings.
Certain investment bank underwriters, the Company, and certain of the
Company's directors and officers have been named in a putative class action for
violation of the federal securities laws in the United States District Court for
the Southern District of New York, captioned In Predictive Systems, Inc. Initial
Public Offering Securities Litigation, 01 Civ. 10059 (SAS). This is one of a
number of cases challenging underwriting practices in the initial public
offerings ("IPOs") of more than 300 companies. These cases have been coordinated
for pretrial proceedings as In re Initial Public Offering Securities Litigation,
21 MC 92 (SAS). Plaintiffs generally allege that certain underwriters engaged in
undisclosed and improper underwriting activities, namely the receipt of
excessive brokerage commissions and customer agreements regarding post-offering
purchases of stock in exchange for allocations of IPO shares. Plaintiffs also
allege that various investment bank securities analysts issued false and
misleading analyst reports. The complaint against the Company claims that the
purported improper underwriting activities were not disclosed in the
registration statements for our IPO and Secondary Offering and seeks unspecified
damages on behalf of a purported class of persons who purchased the Company's
securities or sold put options during the time period from October 27, 1999 to
December 6, 2000. On February 19, 2003, the Court issued an Opinion and Order
denying the Company's motion to dismiss certain of the claims in the complaint.
The Company believes it has meritorious defenses against the allegations in the
complaint and intends to defend the case vigorously.
69
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(15) Commitments And Contingencies: -- (Continued)
On or about November 13, 2002, ICG Communications filed a claim against
the Company in the Federal Bankruptcy Court alleging that approximately $4.3
million in payments that the Company received from ICG within the 90 days
preceding ICG's bankruptcy filing were voidable as preferential transfers under
section 547 of the United States Bankruptcy Code. On March 27, 2003, the Company
and ICG reached an agreement to settle this claim for $350,000. This agreement
is subject to bankruptcy court approval.
In February 28, 2003, Brian Mulvey, a former employee of the Company,
and his wife Nancy Mulvey, filed a lawsuit in the Superior Court of New Jersey
against the Company and four of its managers. The Mulveys have alleged that
during Brian Mulvey's employment with the Company, he was subjected to age
discrimination, sexual harassment and other such conduct. Nancy Mulvey is
Brian's Mulvey's wife, but was never employed with the Company. Plaintiffs seek
an unspecified amount of compensatory damages, emotional distress damages,
punitive damages, attorneys' fees and costs. The Company denies the allegations
of the complaint and plans to vigorously defend the case.
(16) Industry Segment Information:
The Company's reportable segments are US Consulting, International
Consulting, and Managed Security Services. Revenues and cash flows 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 cash flows in the
Managed Security Services segment are generated by providing the following
services: response, threat advisory through Information Sharing and Analysis
Centers, 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." 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 expense. Identifiable assets of the operating segments
principally consist of net accounts receivable, unbilled revenues, advances
under System Integrated Agreement, work-in-process hardware and software,
goodwill and intangible assets. Accounts receivable and unbilled revenues 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 property and
equipment on a segment basis. The table below presents information on the
revenues, operating income (loss) and identifiable assets for each segment for
each of the three years ended December 31, 2002, and items which reconcile
segment operating income (loss) to the Company's reported loss before income tax
provision (benefit).
Year Ended December 31,
-------------------------------------------------------
2002 2001 2000
------------ ------------- ------------
Revenues:
US Consulting $ 37,202,616 $ 54,808,420 $ 82,717,842
International Consulting 8,861,243 7,805,136 8,278,808
Managed Security Services 3,896,350 7,466,717 199,160
------------ ------------- ------------
Total revenues 49,960,209 70,080,273 91,195,810
------------ ------------- ------------
Operating (loss) income:
US Consulting (5,690,429) (45,512,153) 8,311,925
International Consulting (519,962) (4,613,649) 861,354
Managed Security Services (6,457,344) (27,649,302) (21,007)
------------ ------------- ------------
Total operating (loss) income (12,667,735) (77,775,104) 9,232,272
------------ ------------- ------------
70
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(16) Industry Segment Information:-- (Continued)
Corporate expenses:
Sales and marketing (845,470) (2,668,766) (3,481,401)
General and administrative (15,098,351) (22,329,792) (11,618,092)
Depreciation and amortization (1,707,773) (2,872,587) (1,657,311)
Intangibles amortization (1,960,500) (21,932,718) (2,911,727)
Loss on equipment -- (443,498) --
Restructuring and other charges (5,728,478) (14,672,561) --
Loss on long-term investments in related parties -- (2,000,000) --
Noncash charges for stock-based compensation and services (329,155) (275,732) (157,557)
Interest income, net 411,007 2,565,474 7,260,536
Other expense (616,964) (50,819) (268,314)
Interest expense (34,886) (51,845) (190,519)
------------- ------------- -------------
Total corporate expenses (25,910,570) (64,732,794) (13,024,385)
------------- ------------- -------------
Loss before income tax provision (benefit) and
cumulative effect of change in accounting principle $ (38,578,305) $(142,507,898) $ (3,792,113)
============= ============= =============
Goodwill and intangible assets:
US Consulting $ -- $ 19,202,301 $ 68,243,703
International Consulting 1,669,801 2,231,251 3,083,959
Managed Security Services -- 14,809,370 44,113,504
------------- ------------- -------------
Total goodwill and intangible assets $ 1,669,801 $ 36,242,922 $ 115,441,166
============= ============= =============
Other identifiable assets:
US Consulting and Managed Security Services $ 4,963,157 12,257,600 28,705,289
International Consulting 1,552,003 2,444,369 2,919,334
Corporate 24,024,986 51,548,401 99,262,748
------------- ------------- -------------
Total other identifiable assets $ 30,540,146 $ 66,250,370 $ 130,887,371
============= ============= =============
The table below presents information on the revenues for our geographic
locations for each of the three years ended December 31, 2002:
Year Ended December 31,
--------------------------------------------
2002 2001 2000
------------ ------------ ------------
Revenues:
North America $ 41,098,966 $ 62,275,137 $ 82,917,002
Europe 8,861,243 7,805,136 8,278,808
------------ ------------ ------------
Total revenues $ 49,960,209 $ 70,080,273 $ 91,195,810
============ ============ ============
(17) 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.
71
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(17) Restructuring and Other Charges: -- (Continued)
For the year ended December 31, 2001, the Company recorded
restructuring charges of $9,258,454 in connection with its 2001 restructuring
plan. Such charges consisted of $3,364,989 in severance benefits and other
related expenses for a reduction in headcount of 251 employees and $5,893,465 in
exit costs related to real estate and electronic equipment. These charges have
been reflected as operating expenses of the Company. As of December 31, 2001,
restructuring charges of $1,133,316 in connection with the 2001 restructuring
plan remained unpaid and were included in accrued expenses and other current
liabilities on the accompanying consolidated balance sheet.
In December 2001, the Company formed a strategic alliance with an
unaffiliated third party (the "Alliance Partner") to outsource the monitoring
services provided by its 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) non-recoverable costs incurred to convert clients to the Alliance Partner.
For the year ended December 31, 2001, the Company reduced headcount by
12 employees and recorded restructuring charges of $4,384,375 in connection with
the outsourcing of its monitoring services. Such charges consisted of $315,421
in severance benefits, $797,512 in non-recoverable costs to convert clients to
the Alliance Partner and other related charges, and $3,271,442 million for the
write-off of equipment and software development costs associated with the
Company's security operations center which will no longer be needed as a result
of the outsourcing. At December 31, 2001, restructuring charges of $722,224 in
connection with the outsourcing of the Company's monitoring services remained
unpaid and were included in accrued expenses and other current liabilities on
the accompanying consolidated balance sheet. In 2002, the Company reversed
$433,128 of the restructuring charges previously accrued in 2001 in connection
with the outsourcing of the Company's monitoring services. Of this amount,
$150,000 was received from the disposal of equipment previously written-off and
an additional $283,128 was reversed for accruals which were no longer considered
necessary. No amounts were owed as of December 31, 2002.
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. 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 year ended December 31, 2002, the Company recorded
restructuring charges of $5,852,340 in connection with its 2002 restructuring
plan. Such charges consisted of $3,337,320 in severance benefits and other
related expenses for a reduction in headcount of 156 employees, $2,333,741 in
exit costs related to real estate and electronic equipment for the closing of
domestic offices, and an increase to previously accrued exit costs in the amount
of $181,279 resulting from favorable and unfavorable settlements and changes to
subtenant assumptions for leased domestic offices. These charges have been
reflected as operating expenses of the Company. As of December 31, 2002,
restructuring charges of $2,488,767 in connection with the 2001 and 2002
restructuring plans remained unpaid and are included in accrued expenses and
other current liabilities on the accompanying consolidated balance sheet.
In December 2002, the Company's subsidiary in Germany, Predictive AG,
filed for bankruptcy resulting in the closing of the German operations. As a
result, the Company wrote-off the net assets of Predictive AG in the amount of
$284,266 and recorded an additional $25,000 in legal costs associated with the
bankruptcy. These charges have been reflected as operating expenses of the
Company. As of December 31, 2002, restructuring charges of $25,000 in connection
with the Predictive AG bankruptcy remained unpaid and are included in accrued
expenses and other current liabilities on the accompanying consolidated balance
sheet.
72
PREDICTIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
(17) Restructuring and Other Charges: -- (Continued)
A summary of the restructuring and other charges for the year ended
December 31, 2002 and 2001 were as follows:
Balance as Restructuring Utilization Balance as
of 12/31/01 Expense Non-Cash Cash of 12/31/02
------------- -------------- -------------- ----------- -----------
Severance and other related costs $ 17,320 $ 3,337,320 $ -- $ 2,771,647 $ 582,993
Exit Costs 1,115,996 2,515,020 497,319 1,227,923 1,905,774
Predictive AG bankruptcy -- 309,266 157,842 126,424 25,000
Outsourcing monitoring services 722,224 (433,128) -- 289,096 --
----------- ----------- ----------- ----------- -----------
$ 1,855,540 $ 5,728,478 $ 655,161 $ 4,415,090 $ 2,513,767
=========== =========== =========== =========== ===========
Balance as Restructuring Utilization Balance as
of 12/31/00 Expense Non-Cash Cash of 12/31/01
------------- -------------- -------------- ----------- ------------
Severance and other related costs $ -- $ 3,364,989 $ -- $ 3,347,669 $ 17,320
Exit Costs -- 5,893,465 3,430,369 1,347,100 1,115,996
Outsourcing monitoring services -- 4,384,375 3,658,151 4,000 722,224
Abandonment of internal software -- 1,029,732 1,029,732 -- --
----------- ----------- ----------- ----------- -----------
$ -- $14,672,561 $ 8,118,252 $ 4,698,768 $ 1,855,540
=========== =========== =========== =========== ===========
Other charges for the year ended December 31, 2002 consisted of the
write-off of a $1,740,236 advance pursuant to a system integrator agreement with
a supplier of software. During 2002, the supplier filed for bankruptcy. As the
Company was acting as an agent of the supplier in the arrangement for the resale
of this software and the revenues were recognized on a net basis, this write-off
has been classified in restructuring and other charges. Other charges for the
year ended December 31, 2001 consisted of a write-off of $1,029,732 for the
abandonment of internal software management tools for time entry reporting as a
result of the Company's decision to implement a fully integrated system that
better suited its business needs.
(18) Other Income (Expense):
Other income (expense) for the year ended December 31, 2002 included a
reduction in an acquisition related exit cost accrual of $921,175 as a result of
the negotiation of a favorable buyout of a lease, which was assumed in
connection with the Global Integrity acquisition. The liability for such lease
had been fully accrued for as part of the acquired assets and assumed
liabilities of Global Integrity in fiscal 2001. Other income for the year ended
December 31, 2001 primarily consisted of interest income.
(19) Subsequent Events:
Pursuant to the terms of their employment agreements, in January 2003,
the Company issued to two executives of the Company 375,000 and 150,000 shares
of restricted stock (the "Restricted Stock"), respectively, at a price of $0.001
per share pursuant to the 1999 Plan. The Restricted Stock was issued under the
terms and conditions set forth in the 1999 Plan and a stock purchase agreement,
and is subject to a repurchase right by the Company at the per share purchase
price paid by the executive, which repurchase right shall lapse as to 25% of the
Restricted Stock on the first anniversary of January 2, 2003, and in thirty-six
equal monthly installments thereafter as long as the executive is employed by
the Company.
73
Schedule II -- Schedule of Valuation and Qualifying Accounts (in thousands)
Balance at Charged to Balance at
Beginning of Costs and End of
Year Expenses Deduction the Year
For the fiscal year
ended December 31, 2000
Allowance for doubtful
accounts............... $ 568 $ 4,922 $ (4,198) $ 1,292
For the fiscal year
ended December 31, 2001
Allowance for doubtful
accounts............... $ 1,292 $ 4,758 $ (3,444) $ 2,606
Restructuring accrual... -- $13,643 $(11,787) $ 1,856
For the fiscal year
ended December 31, 2002
Allowance for doubtful
accounts............... $ 2,606 $ 84 $ (968) $ 1,722
Restructuring accrual... $ 1,856 $ 5,728 $ (5,070) $ 2,514
74
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
A change in accountants was previously reported on a Current Report on Form 8-K
filed on June 4, 2002.
75
PART III
Item 10. Directors and Executive Officers of the Registrant
The information required by this item is incorporated by reference from
the information under the captions Election of Directors and Executive
Compensation, Management and Other Information contained in a subsequent filing
to be filed with the Securities and Exchange Commission no later than April 30,
2003 (the "Subsequent Filing")
Item 11. Executive Compensation
The information required by this item is incorporated by reference from
the information under the caption Executive Compensation, Management and Other
Information contained in the Subsequent Filing.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by this item is incorporated by reference from
the information under the caption Security Ownership of Certain Beneficial
Owners and Management contained in the Subsequent Filing.
Item 13. Certain Relationships and Related Transactions
The information required by this item is incorporated by reference from
the information under the caption Certain Transactions contained in the
Subsequent Filing.
Item 14. Controls and Procedures
Based on their evaluation of the company's disclosure controls and
procedures as of a date within 90 days of the filing of this Report, the Chief
Executive Officer and Chief Financial Officer have concluded that such controls
and procedures are effective to ensure that information required to be disclosed
by us in reports we file or submit under the Securities Exchange Act of 1934, as
amended, is recorded, processed, summarized and reported within the time periods
specified by the rules and forms of the Securities and Exchange Commission.
There were no significant changes in the company's internal controls or in other
factors that could significantly affect such controls subsequent to the date of
their evaluation. We have not identified any significant deficiencies or
material weaknesses in our internal controls and therefore no corrective actions
were taken.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) The following documents are filed as part of this Report
(1) Financial Statements
Report of Independent Public Accountants
Consolidated Balance Sheets as of December 31, 2002 and 2001
Consolidated Statements of Operations for the Years Ended
December 31, 2002, 2001 and 2000
Consolidated Statements of Stockholders' Equity and
Comprehensive Loss for the Years Ended
December 31, 2002, 2001 and 2000
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2002, 2001 and 2000
Notes to Consolidated Financial Statements
(2) Financial Statement Schedule
Schedule II - Schedule of Valuation and Qualifying Accounts
(3) Exhibits.
See Item 15(c) of this Report below
(b) Reports on Form 8-K
The Company filed three reports on Form 8-K during the three months ended
December 31, 2002 Information regarding the items reported on is as follows:
October 22, 2002. The Company announced the completion of its voluntary stock
option exchange program and the amendment of certain of its CEO's options to
give them the same terms as if they had been eligible for the voluntary option
exchange program.
December 16, 2002. The Company announced that Nasdaq has approved the Company's
application to transfer its common stock from The Nasdaq National Market to
The Nasdaq SmallCap Market, effective at the start of trading on Friday,
December 13, 2002.
December 31, 2002. The Company announced that as part of the restructuring of
its European operations, the Company's German subsidiary, Predictive Systems AG,
had filed for bankruptcy.
76
(c) Exhibits
The following Exhibits are incorporated herein by reference or are filed with
this report as indicated below.
Number Description
------ -----------
3.1(1) Amended and Restated Certificate of Incorporation.
3.2(2) Amended and Restated By-laws.
4.1(3) Specimen common stock certificate.
4.2 See Exhibits 3.1 and 3.2 for provisions of the Amended and Restated
Certificate of Incorporation and Amended and Restated By-laws of the
Registrant defining the rights of holders of Common Stock of the
Registrant.
10.1(3) 1999 Stock Incentive Plan.
10.2(3) 1999 Employee Stock Purchase Plan.
10.3(4) Synet Service Corporation 1996 Stock Option Plan.
10.4(5) Global Integrity Corporation 1998 Stock Incentive Plan.
10.5++ Agreement, dated October 6, 2000, by and between the Registrant and BellSouth MNS, Inc.
10.7(4) Amended and Restated Registration Rights Agreement, dated December 14, 2000.
10.8+++ Professional Services Agreement, dated December 20, 2002, by and between the Registrant
and Pfizer Inc.
10.9(6) Agreement of Lease, dated September 25, 2001, by and between the
Registrant and EBS Forty- Fourth Property Associates LLC.
10.10(7) Employment Agreement, dated as of June 15, 2001, by and between the Registrant and Andrew
Zimmerman.
10.11(8) Employment Agreement, dated as of, by and between the Registrant and Neeraj Sethi.
10.12(9) Employment Agreement, dated as of, by and between the Registrant and Gary Papilsky.
10.13(10) Employment Agreement, dated as of, by and between the Registrant and Shirley Howell.
10.14(11) Service Agreement, dated February 2, 2000, by and between the Registrant and Cisco
Systems, Inc.
10.15++ Professional Services Agreement, effective October 7, 2001, by and
between the Registrant and Science Applications International Corporation
10.16(4) Technical Services Agreement, dated November 17, 2000 by and between Science Applications
International Corporation and Global Integrity Corporation.
10.17(4) Assignment and Cross License Agreement, dated December 6, 2000 by and between Science
Applications International Corporation and Global Integrity Corporation.
10.18(11) Marketing Agreement, dated, August 2, 2001, by and between the
Registrant and BellSouth Telecommunications, Inc.
10.19(3) Investor's Rights Agreement, dated September 16, 1999, by and between Cisco Systems,
Inc. and the Registrant.
10.20++ Professional Services Subcontract, dated May 14, 1999, by and between Cisco Systems,
Inc. and the Registrant.
10.21(12) Employment Agreement, dated as of, by and between the Registrant and Shawn Kreloff.
10.22(13) Consulting Agreement, dated June 27, 2002, by and between the Registrant and Meyer Capital
Meyer Capital Partners LLC.
21.1 List of Subsidiaries.
23.1 Consent of Deloitte & Touche LLP.
24.1 Power of Attorney (see signature page)
99.1 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to
18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(1) Incorporated by reference to Exhibit 3.2 of the Registrant's Registration
Statement on Form S-1, No. 333-84045 (Registration Statement No. 333-
84045).
(2) Incorporated by reference to Exhibit 3.4 of Registration Statement No.
333-84045.
(3) Incorporated by reference to the identically numbered exhibit of
Registration Statement No. 333-84045.
(4) Incorporated by reference to the identically numbered exhibit of the
Registrant's Annual Report on Form 10K for the period ending December 31,
2000.
(5) Incorporated by reference to Exhibit 10.3.1 of the Registrant's Annual
Report on Form 10K for the period ending December 31, 2000.
(6) Incorporated by reference to Exhibit 10.1 of the Registrant's Quarterly
Report on Form 10Q for the period ending September 30, 2001.
(7) Incorporated by reference to Exhibit 10.1 of the Registrant's Quarterly
Report on Form 10Q for the period ending June 30, 2001.
(8) Incorporated by reference to Exhibit 10.1 of the Registrant's Quarterly
Report on Form 10Q for the period ending September 30, 2002.
(9) Incorporated by reference to Exhibit 10.4 of the Registrant's Quarterly
Report on Form 10Q for the period ending September 30, 2002.
77
(10) Incorporated by reference to Exhibit 10.3 of the Registrant's Quarterly
Report on Form 10Q for the period ending September 30, 2002.
(11) Incorporated by reference to the identically numbered exhibit of the
Registrant's Annual Report on Form 10K for the period ending December 31,
2001.
(12) Incorporated by reference to Exhibit 10.2 of the Registrant's Quarterly
Report on Form 10Q for the period ending September 30, 2002.
(13) Incorporated by reference to Exhibit 10.1 of the Registrant's Quarterly
Report on Form 10Q for the period ending June 30, 2002.
+ Non-confidential portions of this Exhibit were filed as the identically
numbered exhibit of Registration Statement No. 333-84045, which non-
confidential portions are incorporated herein by reference. Confidential
treatment was granted for certain portions of this Exhibit pursuant to Rule 406
promulgated under the Securities Act. Confidential portions of this Exhibit have
been filed separately with the Securities and Exchange Commission.
++ Non-confidential portions of this Exhibit were filed as the identically
numbered exhibit of the Registrants Annual Report on Form 10K for the period
ending December 31, 2001, which non-confidential portions are incorporated
herein by reference. Confidential treatment was granted for certain portions of
this Exhibit pursuant to Rule 24b-2 promulgated under the Securities Exchange
Act of 1934, as amended. Confidential portions of this Exhibit have been filed
separately with the Securities and Exchange Commission.
+++ Confidential treatment to be requested for certain portions of this Exhibit
pursuant to Rule 24b-2 promulgated under the Securities Exchange Act of 1934, as
amended. Confidential portions of this Exhibit have been filed separately with
the Securities and Exchange Commission.
78
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, as amended, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized in the City of New York, State of New
York, on this 31st day of March, 2003.
PREDICTIVE SYSTEMS, INC.
By: /s/ Andrew Zimmerman
---------------------------------
Name: Andrew Zimmerman
Title: Chief Executive Officer
KNOW ALL MEN BY THESE PRESENT that each individual whose signature appears
below constitutes and appoints Andrew Zimmerman and Neeraj Sethi jointly and
severally such person's true and lawful attorney-in-fact and agent each with
full power of substitution and resubstitution, for such person and in such
person's name, place and stead, in any and all capacities, to sign any and all
amendments to this Report, and to file the same, with all exhibits thereto, and
all documents in connection therewith, with the Securities and Exchange
Commission, granting unto said attorney-in-fact and agent full power and
authority to do and perform each and every act and thing requisite and necessary
to be done in and about the premises, as fully to all intents and purposes as
such person might or could do in person, hereby ratifying and confirming all
that said attorney-in-fact and agent, or any substitute or substitutes of any of
them, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
this Report has been signed by the following persons in the capacities
indicated.
79
Signature Title(s) Date
--------- -------- ----
/s/ Andrew Zimmerman Chief Executive Officer and Director March 31, 2003
------------------------------------- (principal executive officer)
Andrew Zimmerman
/s/ Neeraj Sethi Chief Financial Officer (principal March 31, 2003
------------------------------------- financial and accounting officer)
Neeraj Sethi
/s/ Peter L. Bloom Director March 31, 2003
-------------------------------------
Peter L. Bloom
/s/ Eric Meyer Director March 31, 2003
-------------------------------------
Eric Meyer
/s/ Howard Morgan Director March 31, 2003
-------------------------------------
Howard Morgan
/s/ Inder Sidhu Director March 31, 2003
-------------------------------------
Inder Sidhu
/s/ William L. Smith Director March 31, 2003
-------------------------------------
William L. Smith
/s/ William W. Wyman Chairman of the Board of Directors March 31, 2003
-------------------------------------
William W. Wyman
80
CERTIFICATION PURSUANT TO RULE 13A-14 OR 15D-14 OF THE SECURITIES
EXCHANGE ACT OF 1934, AS ADOPTED PURSUANT TO SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002
I, Andrew Zimmerman, certify that:
1. I have reviewed this annual report on Form 10-K of Predictive Systems, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report is
being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 31, 2003
/s/ Andrew Zimmerman
--------------------------
Andrew Zimmerman
Chief Executive Officer
81
CERTIFICATION PURSUANT TO RULE 13A-14 OR 15D-14 OF THE SECURITIES
EXCHANGE ACT OF 1934, AS ADOPTED PURSUANT TO SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002
I, Neeraj Sethi, certify that:
1. I have reviewed this annual report on Form 10-K of Predictive Systems, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report is
being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 31, 2003
/s/ Neeraj Sethi
--------------------------
Neeraj Sethi
Chief Financial Officer
82