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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
Commission file number: 0-22141
COVANSYS CORPORATION
(Exact Name of Registrant as Specified in its Charter)
| Michigan (State or Other Jurisdiction of Incorporation or Organization) | 38-2606945 (IRS Employer Identification No.) |
32605 West Twelve Mile Road
Suite 250
Farmington Hills, Michigan 48334
(Address of Principal Executive Offices and Zip Code)
Registrant’s telephone number, including area code:(248) 488-2088
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesx Noo
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) Yesx Noo
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Nox
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
| No Par Value (Class of Common Stock) | 37,345,924 (Outstanding as of October 20, 2005) |
COVANSYS CORPORATION
INDEX
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
COVANSYS CORPORATION AND SUBSIDIARIES
condensed consolidated balance sheets
| September 30, | December 31, | |||||||||
| 2005 | 2004 | |||||||||
| (Dollars in thousands) | ||||||||||
| (Unaudited) | ||||||||||
ASSETS | ||||||||||
| Current assets: | ||||||||||
| Cash and cash equivalents | $ | 52,939 | $ | 49,841 | ||||||
| Short-term investments | 14,349 | 21,409 | ||||||||
| Accounts receivable net of allowance for doubtful accounts of $1,772 and $1,532 at September 30, 2005 and December 31, 2004 | 93,929 | 75,388 | ||||||||
| Revenue earned in excess of billings | 25,428 | 24,613 | ||||||||
| Deferred taxes | 5,259 | 5,105 | ||||||||
| Prepaid expenses and other | 7,539 | 7,226 | ||||||||
| Total current assets | 199,443 | 183,582 | ||||||||
| Property and equipment, net | 32,251 | 29,762 | ||||||||
| Computer software, net | 2,540 | 3,706 | ||||||||
| Goodwill | 19,336 | 19,148 | ||||||||
| Deferred taxes | 5,586 | 5,808 | ||||||||
| Other assets, net | 6,299 | 6,796 | ||||||||
| Total assets | $ | 265,455 | $ | 248,802 | ||||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||||||
| Current liabilities: | ||||||||||
| Current portion of long-term debt | $ | — | $ | 17,500 | ||||||
| Accounts payable | 15,705 | 14,052 | ||||||||
| Accrued payroll and related costs | 21,440 | 16,744 | ||||||||
| Taxes payable | 1,200 | 3,481 | ||||||||
| Other accrued liabilities | 21,183 | 18,331 | ||||||||
| Deferred revenue | 2,523 | 1,041 | ||||||||
| Total current liabilities | 62,051 | 71,149 | ||||||||
| Other liabilities | 4,432 | 3,462 | ||||||||
| Commitments and contingencies | ||||||||||
| Shareholders’ equity: | ||||||||||
| Preferred stock, no par value, 1,000,000 shares authorized, none issued | — | — | ||||||||
| Common stock, no par value, 200,000,000 shares authorized, 37,338,927 and 37,418,764 shares issued and outstanding as of September 30, 2005 and December 31, 2004, respectively | — | — | ||||||||
| Additional paid-in capital | 164,795 | 165,983 | ||||||||
| Retained earnings | 34,355 | 6,433 | ||||||||
| Accumulated other comprehensive income (loss) | (178 | ) | 1,775 | |||||||
| Total shareholders’ equity | 198,972 | 174,191 | ||||||||
| Total liabilities and shareholders’ equity | $ | 265,455 | $ | 248,802 | ||||||
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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COVANSYS CORPORATION AND SUBSIDIARIES
condensed consolidated statements of operations
| Three Months Ended | Nine Months Ended | |||||||||||||||||
| September 30, | September 30, | |||||||||||||||||
| 2005 | 2004 | 2005 | 2004 | |||||||||||||||
| (In thousands, except per share data) | ||||||||||||||||||
| (Unaudited) | ||||||||||||||||||
| Revenue | $ | 111,178 | $ | 96,201 | $ | 324,159 | $ | 275,203 | ||||||||||
| Cost of revenue | 82,182 | 70,085 | 234,433 | 208,931 | ||||||||||||||
| Gross profit | 28,996 | 26,116 | 89,726 | 66,272 | ||||||||||||||
| Selling, general and administrative expenses | 17,650 | 16,931 | 54,652 | 55,780 | ||||||||||||||
| Income from operations | 11,346 | 9,185 | 35,074 | 10,492 | ||||||||||||||
| Interest expense | 26 | 43 | 495 | 43 | ||||||||||||||
| Other income, net | 621 | 543 | 1,428 | 1,852 | ||||||||||||||
| Income before provision for income taxes | 11,941 | 9,685 | 36,007 | 12,301 | ||||||||||||||
| Provision for income taxes | 3,331 | 3,118 | 8,092 | 4,019 | ||||||||||||||
| Net income | 8,610 | 6,567 | 27,915 | 8,282 | ||||||||||||||
| Convertible redeemable preferred stock dividends | — | 953 | — | 3,221 | ||||||||||||||
| Loss on redemption of convertible redeemable preferred stock | — | 28,674 | — | 28,674 | ||||||||||||||
| Net income (loss) available for common shareholders | $ | 8,610 | $ | (23,060 | ) | $ | 27,915 | $ | (23,613 | ) | ||||||||
| Earnings (loss) per share | ||||||||||||||||||
| Basic | $ | .23 | $ | (.81 | ) | $ | .75 | $ | (.86 | ) | ||||||||
| Diluted | $ | .23 | $ | (.81 | ) | $ | .74 | $ | (.86 | ) | ||||||||
| Basic weighted average shares | 37,281 | 28,616 | 37,355 | 27,455 | ||||||||||||||
| Dilutive effect of options and warrants | 668 | (A) | 580 | (A) | ||||||||||||||
| Convertible redeemable preferred stock | — | (A) | — | (A) | ||||||||||||||
| Diluted weighted average shares | 37,949 | 28,616 | 37,935 | 27,455 | ||||||||||||||
| (A) | Anti-dilutive |
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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COVANSYS CORPORATION AND SUBSIDIARIES
condensed consolidated statements of cash flows
| Nine Months Ended | |||||||||||
| September 30, | |||||||||||
| 2005 | 2004 | ||||||||||
| (Dollars in thousands) | |||||||||||
| (Unaudited) | |||||||||||
| Cash flows from operating activities: | |||||||||||
| Net income | $ | 27,915 | $ | 8,282 | |||||||
| Adjustments to reconcile net income to net cash used in operating activities: | |||||||||||
| Depreciation and amortization | 9,881 | 10,032 | |||||||||
| Loss on disposal and obsolescence of property and equipment | 302 | 1,066 | |||||||||
| Provision for and write-off of doubtful accounts | 240 | 1,562 | |||||||||
| Provision for deferred income taxes | 12 | — | |||||||||
| Gain from sale of short-term investments | (48 | ) | (132 | ) | |||||||
| Other | 272 | 163 | |||||||||
| Change in assets and liabilities: | |||||||||||
| Accounts receivable and revenue earned in excess of billings | (19,934 | ) | (1,930 | ) | |||||||
| Prepaid expenses and other | 790 | 324 | |||||||||
| Accounts payable, accrued payroll and related costs and other liabilities | 8,193 | 5,948 | |||||||||
| Net cash provided from operating activities | 27,623 | 25,315 | |||||||||
| Cash flows from investing activities: | |||||||||||
| Acquisition of business, net of cash acquired | (3,027 | ) | — | ||||||||
| Investment in property, equipment and other | (9,949 | ) | (6,646 | ) | |||||||
| Investment in computer software | (43 | ) | (171 | ) | |||||||
| Proceeds from sale of available for sale securities | 102,494 | 85,994 | |||||||||
| Purchases of available for sale securities | (94,225 | ) | (69,343 | ) | |||||||
| Net cash provided by (used in) investing activities | (4,750 | ) | 9,834 | ||||||||
| Cash flows from financing activities: | |||||||||||
| Repayment of subordinated notes | (17,500 | ) | — | ||||||||
| Net proceeds from issuance of common stock and warrants | — | 93,374 | |||||||||
| Net proceeds from exercise of stock options and other | 2,916 | 1,025 | |||||||||
| Repurchases of common stock | (4,803 | ) | (2,407 | ) | |||||||
| Redemption of convertible redeemable preferred stock and warrants | — | (178,977 | ) | ||||||||
| Net cash used in financing activities | (19,387 | ) | (86,985 | ) | |||||||
| Effect of exchange rate changes on cash | (388 | ) | 25 | ||||||||
| Increase (decrease) in cash and cash equivalents | 3,098 | (51,811 | ) | ||||||||
| Cash and cash equivalents at beginning of period | 49,841 | 89,671 | |||||||||
| Cash and cash equivalents at end of period | $ | 52,939 | $ | 37,860 | |||||||
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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COVANSYS CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data)
(Unaudited)
1. Organization and Basis of Presentation
Covansys Corporation was founded in 1985. Covansys Corporation and its subsidiaries (the Company) is a global technology services company, with a focus on industry-specific solutions, strategic outsourcing and integration solutions. The Company addresses the most challenging technology issues companies are facing through an onsite, offsite, offshore delivery model that helps clients achieve rapid deployment and reduced costs. The Company offers high-level subject matter expertise in the public sector industry, as well as years of experience in retail, healthcare, distribution, manufacturing, financial services, telecommunications and utilities. The Company applies its industry-specific knowledge to deliver a wide range of outsourcing and integration services, including: application maintenance and development outsourcing (AMD/O); custom application development; e-business services; packaged software implementation, upgrades and enhancements; and other services.
The accompanying unaudited condensed consolidated financial statements have been prepared by management pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, including normal recurring adjustments, necessary to present fairly the financial position of Covansys Corporation and subsidiaries as of September 30, 2005, the results of its operations for the three and nine month periods ended September 30, 2005 and 2004, and cash flows for the nine month periods ended September 30, 2005 and 2004. These financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s 2004 Annual Report on Form 10-K for the year ended December 31, 2004.
The results of operations for the three and nine month periods ended September 30, 2005 are not necessarily indicative of the results to be expected in future quarters or for the year ending December 31, 2005.
2. Recapitalization
On April 27, 2004, the Company announced that it had entered into a long-term Master Services Agreement and a Stock Purchase Agreement with Fidelity Information Services (“FIS”), Inc., a subsidiary of Fidelity National Financial, Inc. Under the Stock Purchase Agreement, as amended, with FIS and approved by shareholders on September 15, 2004, the Company issued to FIS 8,700,000 shares of the Company’s common stock and warrants for $95,700. The four tranches of warrants, each for 1,000,000 shares of the Company’s common stock, have a strike price of $15.00, $17.50, $20.50 and $24.00 per share. FIS also acquired 2,300,000 shares of the Company’s common stock from Rajendra Vattikuti, Chief Executive Officer of the Company.
In order to facilitate the transactions with FIS, the Company also entered into a Recapitalization Agreement, as amended, with a wholly-owned subsidiary of a private equity investment fund managed by Clayton, Dubilier & Rice, Inc. (the “CDR Stockholder”) to restructure the CDR Stockholder’s ownership interest in the Company and certain corresponding governance rights, in exchange for a combination of cash, stock, notes and warrants. The CDR Stockholder owned 200,000 shares of the Company’s Series A Voting Convertible Preferred Stock, or approximately 8,695,000 shares of common stock on an as converted basis, and 5,300,000 million common stock warrants with a strike price ranging from $25 to $31 per share.
Under the terms of the Recapitalization Agreement approved by shareholders on September 15, 2004 the CDR Stockholder exchanged all of its existing holdings in the Company for consideration valued at $227,700 consisting of $177,500 of cash, 2,000,000 shares of common stock of the Company, subordinated notes in the
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total amount of $17,500 due December 31, 2005, which bears interest at LIBOR plus 2.20%, and five-year warrants for five million shares of common stock with a strike price of $18 per share. In accordance with EITF D-42, as amended by EITF 00-27, the Company recorded a reduction to income available to common shareholders of $28,674 in the third quarter of 2004. The Company financed the transaction with the CDR Stockholder with cash on hand as well as proceeds from the FIS investment. The $17,500 subordinated notes were repaid by the Company in July 2005.
3. Acquisition
On September 15, 2005, the Company’s wholly owned subsidiary, Covansys India Limited acquired 75% of the outstanding common shares of Fortune Infotech Limited for approximately $3,200 million, which was funded with existing cash of Covansys India Limited. The acquisition has been accounted for as a purchase. Had the acquisition occurred as of January 1, 2004, there would not have been a material impact on revenue, net income or earnings per share.
The excess of purchase price over net assets acquired has been reflected as goodwill in the accompanying financial statements pending the completion of an independent appraisal of the net assets acquired.
Fortune, with its principal office located in Baroda, India, is an experienced provider of offshore outsourcing solutions. Fortune focuses on business process outsourcing (BPO) and provides back office services such as transaction processing, claim processing and accounts payable processing services. The transaction will enhance the Company’s BPO capabilities and increase its ability to meet the needs of existing and prospective clients.
4. Income Taxes
The Company has provided federal, foreign and state income taxes in the condensed consolidated statements of operations based on the anticipated effective tax rate for fiscal years 2005 and 2004. The Company’s tax rate is impacted by permanent items such as Subpart F income and nondeductible travel and entertainment expenses as well as the mix between domestic and foreign earnings.
Realization of deferred tax assets associated with the Company’s future deductible temporary differences and net operating loss carryforwards is dependent upon generating sufficient taxable income prior to their expiration. Although realization of the deferred tax assets is not assured, management believes it is more likely than not that the deferred tax assets will be realized through future taxable income. On a quarterly basis, management assesses whether it remains more likely than not that the deferred tax assets will be realized.
The Company has six (five in 2004) business units in India which are entitled to a tax holiday for 10 consecutive years commencing with the year the business unit started producing computer software or until the Indian tax year ending March 31, 2009, whichever is earlier. The business units are subject to the tax holiday for various periods through March 31, 2009. As the tax holiday expires, the Company’s overall effective tax rate will be negatively impacted.
The Company’s tax rate in the third quarter of 2005 was impacted by the reversal of previously recorded valuation allowances of $369 that were no longer required. In addition, the nine month tax rate was impacted by the reversal of previously recorded tax reserves of $3,200 due to the expiration of the statute of limitations for the tax years the recorded reserves related to and a charge of $500 from the reversal of deferred tax assets due to an enacted law change in the State of Ohio which will reduce the amount of net operating losses that the Company will be able to utilize in future periods.
5. Fixed Price Contracts
The Company realized approximately 43.0%, 41.0%, 42.6% and 39.9% of its revenue during the three months and nine months ended September 30, 2005 and 2004, respectively, from fixed price contracts (percentage of completion as well as fixed price IT outsourcing and maintenance). Approximately 17.1%, 11.6%, 15.1% and 12.2% of the Company’s revenue during the three months and nine months ended September 30, 2005 and 2004, respectively, was realized from fixed price contracts with respect to which the
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Company recognizes revenue on a percentage of completion basis. These contracts expose the Company to collection risk on both billed and unbilled receivables in the event that contract milestones are not met or the client does not accept the product as delivered. In addition, the Company could incur unanticipated losses if it is necessary to increase its estimated cost to complete.
The Company’s first quarter and third quarter 2004 financial results were negatively impacted by approximately $9,400 and $1,250 respectively, due to four significant fixed price contracts which it considers to be challenged. No such adjustment was required in 2005 for the remaining troubled project.
Communications with contracting parties during 2004 caused management to re-assess the collectibility of billed and unbilled receivables for two troubled projects. In both cases, the Company had been informed that its services would no longer be required to complete the project prior to its implementation. As a result, the Company reduced the related receivables by $5,500 and $350 to their net realizable value in the first quarter and third quarter of 2004, respectively. In accordance with the application of percentage of completion accounting, the Company reflected the changes as a contract price adjustment, and accordingly, as a reduction in revenue.
The Company also determined it was necessary to increase its estimated cost to complete for three of these projects due to changes in 2004 in both scope and resource requirements. The revision in estimates had the effect of reducing gross margin by $3,900 and $900 in the first quarter and third quarter of 2004, respectively.
The Company has $4,310 in billed and unbilled receivables related to the remaining active contract.
6. Segment Information
The Company is a provider of IT services, and is organized geographically throughout North America, India and Asia, and other international locations. The chief operating decision-maker evaluates each location’s performance based primarily on its revenues and income from operations due to the similarity of the nature of services provided to clients. Revenue for the India/Asia operation is evaluated based on the full attribution of bill rates charged to the end customer. The segment revenue figures disclosed below are stated at full attribution. Full attribution revenue is calculated using the end customer invoice rate on intersegment engagements, as opposed to using the transfer price rate. The chief operating decision-maker does not evaluate segment performance based on assets. Assets, including the related depreciation and amortization expense, are managed primarily by corporate management. Under this organization, the operating segments have been aggregated into the following four operating segments and other.
| • | Public Sector includes all services provided to federal, state and local municipalities. | |
| • | Commercial includes all U.S. operations services provided to non-public sector customers exclusive of services provided to FIS. Commercial includes application services for maintenance and development outsourcing (AMD/O), retail, healthcare, distribution, manufacturing, financial services, telecommunications, utilities, e-business, packaged software implementation and other services. Commercial also includes telecommunication services provided in Europe. | |
| • | India/Asia includes all services performed in India or Asia, Canada as well as non telecommunication services provided in Europe and services provided to FIS. | |
| • | Other consists primarily of the labor and supporting expenses for the Corporate functions, depreciation and amortization expenses as well as lease expenses for corporate headquarters. |
The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies in the Company’s 2004 Annual Report on Form 10-K.
India/Asia supplies substantial resources to U.S. operations customers. The rate charged by India to U.S. operations has been developed utilizing a cost plus transfer pricing methodology. This results in a large component of the available gross margin accruing to U.S. operations where the end customer is located.
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Revenue and income from operations by segment is as follows:
| Three Months Ended | Nine Months Ended | |||||||||||||||||
| September 30, | September 30, | |||||||||||||||||
| 2005 | 2004 | 2005 | 2004 | |||||||||||||||
| Revenue | ||||||||||||||||||
| Commercial | $ | 66,251 | $ | 59,176 | $ | 192,060 | $ | 175,647 | ||||||||||
| Less intersegment | (2,302 | ) | (156 | ) | (5,864 | ) | (520 | ) | ||||||||||
| 63,949 | 59,020 | 186,196 | 175,127 | |||||||||||||||
| Public Sector | 27,628 | 24,235 | 83,065 | 69,797 | ||||||||||||||
| India/Asia | 42,535 | 33,647 | 120,130 | 88,401 | ||||||||||||||
| Less intersegment | (22,934 | ) | (20,701 | ) | (65,232 | ) | (58,122 | ) | ||||||||||
| 19,601 | 12,946 | 54,898 | 30,279 | |||||||||||||||
| $ | 111,178 | $ | 96,201 | $ | 324,159 | $ | 275,203 | |||||||||||
| Income from Operations | ||||||||||||||||||
| Commercial | $ | 14,976 | $ | 12,941 | $ | 44,792 | $ | 35,087 | ||||||||||
| Public Sector | 1,316 | 1,459 | 7,854 | (2,138 | ) | |||||||||||||
| India/Asia | 4,427 | 3,586 | 11,098 | 5,650 | ||||||||||||||
| Corporate and Other | (9,373 | ) | (8,801 | ) | (28,670 | ) | (28,107 | ) | ||||||||||
| 11,346 | 9,185 | 35,074 | 10,492 | |||||||||||||||
| Interest expense | 26 | 43 | 495 | 43 | ||||||||||||||
| Other income, net | 621 | 543 | 1,428 | 1,852 | ||||||||||||||
| Income before Provision for Income Taxes | $ | 11,941 | $ | 9,685 | $ | 36,007 | $ | 12,301 | ||||||||||
7. Property and Equipment
Subsequent to the original issuance of its financial statements for the year ended December 31, 2003, the Company identified $2,561 of adjustments related to property and equipment, $1,495 of which related to prior periods requiring the Company to restate its previously filed financial statements for all periods affected by the charge. The remaining $1,066 was recorded in the first quarter of 2004, $742 of which relates to equipment that the Company has been unable to determine the period or periods during which the equipment left its possession and $324 of which relates to equipment that became obsolete in the first quarter of 2004.
Of the first quarter 2004 charge of $1,066, $39 was recorded in cost of revenue and $1,027 was recorded in selling, general and administrative expense.
8. Common Stock Repurchase Program
The Company’s board of directors has authorized the repurchase of up to 14,000,000 shares of the Company’s common stock. Through September 30, 2005, the Company has repurchased approximately 11,838,176 shares of its common stock for cash, at a total cost of $146,783. The Company repurchased 403,200 shares at a cost of $4,803 during the nine month period ended September 30, 2005. As of September 30, 2005, 2,161,824 shares remain available for repurchase under the board of directors authorization.
9. Net Income (Loss) Per Share
Basic and diluted net income (loss) per share is computed in accordance with SFAS No. 128, “Earnings Per Share, as amended by Emerging Issues Task Force (“EITF”) Issue 03-6 by dividing net income (loss) available for common shareholders by the weighted average number of shares of common stock outstanding. The calculation of dilutive net income (loss) per share excludes the following common stock equivalents for the respective periods because their impact was anti-dilutive.
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| Three Months Ended | Nine Months Ended | |||||||||||||||
| September 30, | September 30, | |||||||||||||||
| 2005 | 2004 | 2005 | 2004 | |||||||||||||
| Common stock equivalents related to convertible redeemable preferred stock | — | 7,246,376 | — | 8,207,630 | ||||||||||||
| Warrants issued to CDR to purchase 5,300,000 shares of common stock | — | 4,416,667 | — | 5,002,551 | ||||||||||||
| Warrants issued to CDR to purchase 5,000,000 shares of common stock | 5,000,000 | 833,333 | 5,000,000 | 280,612 | ||||||||||||
| Warrants issued to FIS to purchase 4,000,000 shares of common stock | 3,000,000 | 666,667 | 3,000,000 | 224,490 | ||||||||||||
| Average number of stock options outstanding | 819,692 | 2,429,269 | 510,221 | 2,452,312 | ||||||||||||
The Company’s Series A Voting Convertible Preferred Stock was a participating security as defined in Issue 03-6. The Company adopted Issue 03-6 in 2004. The adoption of Issue 03-6 results in a reduction in EPS available for common shareholders in periods where the Company has income and has no impact in periods where the Company has a loss. The Company’s Series A Voting Convertible Preferred Stock was redeemed as part of the Recapitalization Agreement with the CDR Shareholder (see Note 2).
10. Stock Option Plans
The Company has elected to account for stock options using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no additional compensation expense has been recognized for our stock option plan within the accompanying consolidated statements of operations. Had compensation expense for our stock option plan been determined based on the fair value at the grant date consistent with the provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” the Company’s pro forma net income (loss) available for common shareholders and pro forma basic and diluted net (loss) per common share would have been reduced to the amounts indicated below:
| Three Months Ended | Nine Months Ended | ||||||||||||||||
| September 30, | September 30, | ||||||||||||||||
| 2005 | 2004 | 2005 | 2004 | ||||||||||||||
| Net income (loss) available for common shareholders: | |||||||||||||||||
| As reported | $ | 8,610 | $ | (23,060 | ) | $ | 27,915 | $ | (23,613 | ) | |||||||
| Stock-based employee compensation cost included in the determination of net (loss) from operations as reported | — | 192 | — | 192 | |||||||||||||
| Stock-based employee compensation cost had the fair value method been used | 640 | 22 | 2,126 | 1,213 | |||||||||||||
| SFAS No. 123 pro forma | $ | 7,970 | $ | (22,890 | ) | $ | 25,789 | $ | (24,634 | ) | |||||||
| Basic and diluted (loss) per share: | |||||||||||||||||
| As reported-basic | $ | .23 | $ | (.81 | ) | $ | .75 | $ | (.86 | ) | |||||||
| As reported-diluted | $ | .23 | $ | (.81 | ) | $ | .74 | $ | (.86 | ) | |||||||
| SFAS No. 123 pro forma-basic | $ | .21 | $ | (.80 | ) | $ | .69 | $ | (.90 | ) | |||||||
| SFAS No. 123 pro forma-diluted | $ | .21 | $ | (.80 | ) | $ | .68 | $ | (.90 | ) | |||||||
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11. Comprehensive Income
Total comprehensive income is summarized as follows:
| Three Months Ended | Nine Months Ended | ||||||||||||||||
| September 30, | September 30, | ||||||||||||||||
| 2005 | 2004 | 2005 | 2004 | ||||||||||||||
| Net income | $ | 8,610 | $ | 6,567 | $ | 27,915 | $ | 8,282 | |||||||||
| Currency translation adjustment | (60 | ) | 535 | (1,983 | ) | (466 | ) | ||||||||||
| Unrealized gains on short-term investments upon sale | — | — | 30 | — | |||||||||||||
| Total comprehensive income | $ | 8,550 | $ | 7,102 | $ | 25,962 | $ | 7,816 | |||||||||
12. Credit Agreement
On September 7, 2004, the Company entered into a new Credit Agreement which provides for borrowings or standby and commercial letters of credit up to $30,000. The Credit Agreement expires on December 28, 2005 but may be extended in one-year increments at the request of the Company and the consent of the lenders. With the prior consent of the Agent, the Company may request to increase the availability under the Credit Agreement by up to $10,000 (not to exceed an aggregate availability of $40,000). Borrowings under the Credit Agreement are collateralized by all domestic assets of the Company.
Borrowings under the Credit Agreement bear interest at LIBOR plus 1.20% to 1.55% or prime minus .50%. The interest rate matrix is based on the Company’s level of outstanding credit exposure as defined in the Credit Agreement. Under the Credit Agreement, the Company pays a commitment fee of .125% per annum on the unused portion of the commitment and a facility letter of credit fee of .90% to 1.55% per annum based on the level of outstanding credit exposure as defined in the Credit Agreement.
The Credit Agreement contains covenants which include financial covenants which require the Company to maintain a certain interest coverage ratio, leverage ratio and a minimum total capitalization. At September 30, 2005, the Company was in compliance with these ratios. At September 30, 2005, the Company had no borrowings and $9,386 in outstanding letters of credit under this Credit Agreement. The Credit Agreement also includes a covenant which restricts the Company’s ability to repurchase shares of its common stock in 2005 in excess of $20,000 absent approval from the lenders.
13. Related Party Transactions
On September 15, 2004, the Company issued 8,700,000 shares of common stock and 4,000,000 warrants to FIS for $95,700 (See Note 2). In the second quarter of 2004, the Company entered into a Master Services Agreement with FIS to provide services over a five year period. Services provided by the Company to FIS during the three and nine months ended September 30, 2005 and 2004, respectively, totaled approximately $4,887, $1,058, $12,321 and $1,058, respectively. The balance owed to the Company by FIS at September 30, 2005 was $5,001.
Synova, Inc. and subsidiaries (Synova) is an IT professional services organization owned by the Chairman of the Company’s Board of Directors. During the three month periods ended September 30, 2005 and 2004, the Company provided services to Synova totaling $485 and $647, respectively and $1,569 and $1,954 for the nine month periods ended September 30, 2005 and 2004, respectively. In addition, during the three month periods ended September 30, 2005 and 2004 Synova provided services to the Company totaling $1,239 and $572, respectively and $2,930 and $1,154 for the nine month periods ended September 30, 2005 and 2004, respectively. The net balance owed by the Company to Synova at September 30, 2005 was $134. As of September 30, 2005, the Synova note payable balance to the Company of $2,500 has been paid.
The Company paid approximately $104 to CDR, a shareholder, for financial, management advisory, and executive management services during the three month period ended September 30, 2004 and $494 for the nine month periods ended September 30, 2004. No such services were provided by CDR during the three and
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nine month ended September 30, 2005. During the three and nine months ended September 30, 2005 the Company paid interest of $294 and $644, respectively, to CDR in accordance with the terms of the $17,500 subordinated notes due December 31, 2005 which were issued in connection with the FIS/CDR transaction as further described in Note 2. On July 5, 2005 the Company repaid the $17,500 subordinated notes and accrued interest of $294.
The Company provides outsourcing services to SIRVA, Inc. a company related through common ownership of CDR. During the three month and nine month periods ended September 30, 2005 and 2004, services provided by the Company to SIRVA, Inc. totaled approximately $2,104 and $1,989 and $6,569 and $6,741, respectively. The net balance owed to the Company by SIRVA at September 30, 2005 was $772.
14. Restructuring and Other Related Charges
The following is a roll forward of the accrual balance for Restructuring and Other Related charges for the nine month periods ended September 30, 2004 and 2003 respectively.
| Lease | ||||||||||||
| Severance | Terminations | Total | ||||||||||
| Balance January 1, 2005 | $ | 67 | $ | 2,174 | $ | 2,241 | ||||||
| Expense | — | 325 | 325 | |||||||||
| Payments and other | (67 | ) | (1,072 | ) | (1,139 | ) | ||||||
| Balance September 30, 2005 | $ | — | $ | 1,427 | $ | 1,427 | ||||||
| Balance January 1, 2004 | $ | 371 | $ | 1,668 | $ | 2,039 | ||||||
| Expense | 1,594 | 2,226 | 3,820 | |||||||||
| Payments and other | (1,841 | ) | (1,876 | ) | (3,717 | ) | ||||||
| Balance September 30, 2004 | $ | 124 | $ | 2,018 | $ | 2,142 | ||||||
Amounts related to lease terminations will be paid out through June 2011.
15. Cost of Computer Software to be Sold, Leased or Marketed
SFAS No. 86 “Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed” requires capitalized software development costs incurred subsequent to establishment of technological feasibility and prior to the availability of the product for general release to customers. During the nine months ended September 30, 2005 the Company capitalized computer software of approximately $43. Amortization of capitalized costs begins when the product is available for general release to customers and is computed on a straight-line basis over each products estimated economic life — typically five years. Amortization costs were $358 and $422 for the three months ended September 30, 2005 and 2004, respectively and $1,192 and $1,265 for the nine months ended September 30, 2005 and 2004, respectively.
16. Goodwill
Changes in the carrying amount of goodwill for the nine months ended September 30, 2005 is as follows:
| Balance January 1, 2005 | $ | 19,148 | ||
| Acquisition of Fortune Infotech Limited | 584 | |||
| Currency translation | (396 | ) | ||
| Balance September 30, 2005 | $ | 19,336 | ||
17. Other Income, Net
Other income, net represents interest earned and realized gains and losses from the sale of short-term and long-term investments and cash equivalents and foreign currency transaction and translation gains and losses.
Foreign currency fluctuations during the nine months ended September 30, 2005 and 2004 resulted in a foreign currency translation gain/(loss) of approximately $23 and ($139) respectively, from the remeasure-
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ment of nonfunctional currency net asset positions into the functional currency of the respective foreign subsidiary.
18. Recently Issued Financial Accounting Standards
In December 2004 the FASB issued FAS 123R, “Share-Based Payment”, that requires companies to expense the value of employee stock options and similar awards. The effective date for application by public companies is annual periods beginning after June 15, 2005. FAS 123R applies to all outstanding and unvested share-based payment awards at a Company’s adoption date. FAS 123R allows alternative transition methods. The Company has not yet selected a transition method. Management is presently reviewing the impact on our results of operations and financial position from implementing FAS 123R.
In December 2004, the FASB issued an FASB Staff Position (FSP) 109-2 “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004”, which provides accounting and disclosure guidance for the foreign earnings repatriation provision within the American Jobs Creation Act of 2004. The Act provides special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer. FSP FASB 109-2 provides for a period of time beyond the financial reporting period of enactment for a company to evaluate the effect of the Act on its plan for reinvestment or repatriation of foreign earnings. The Company is in the process of evaluating the effects of one-time repatriation opportunities provided by the Act. At the time of filing these statements, the Company cannot reasonably estimate the income tax effects of such repatriation under the Act.
In May 2005, the FASB issued FAS 154, “Accounting Changes and Error Corrections”, a replacement of APB Opinion No. 20 and FASB Statement No. 3. Previously, APB No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements” required the inclusion of the cumulative effect of changes in accounting principle in net income of the period of the change. FAS 154 requires companies to recognize changes in accounting principle, including changes required by a new accounting pronouncement when the pronouncement does not include specific transition provisions, retrospectively to prior periods’ financial statements, unless impracticable to determine the effects of the change. The effective date for application by public companies is annual periods beginning after December 15, 2005. The Company will assess the impact of a retrospective application of a change in accounting principle in accordance with FAS 154 if the need for such a change arises after the effective date.
19. Disposition of Development Center
On May 3, 2005, Oracle announced that it has exercised its purchase option to acquire PeopleSoft’s development center in Bangalore, India operated by the Company. The transfer of this center is expected to be completed in November, 2005, upon which the employees of the center (approximately 500 at September 30, 2005) will become employees of Oracle. Revenue generated from this development center for the Company was approximately $8,400, $4,030 and $12,139 for the year ended December 31, 2004 and the three and nine months ended September 30, 2005, respectively. Under terms of the agreement, Oracle will pay a buyout fee of approximately $1,200 and an amount equal to the book value of the net assets related to this business.
20. Contingencies
We are involved in tax and legal proceedings, claims and litigation arising in the ordinary course of business, including potential claims relating to tax liabilities for employees of foreign subsidiaries. We periodically assess our liabilities and contingencies in connection with these matters, based upon the latest information available. For those matters where it is probable that we have incurred a loss and the loss or range of loss can be reasonably estimated, we have recorded reserves in the consolidated financial statements. In other instances, because of the uncertainties related to both the probable outcome and amount or range of loss, we are unable to make a reasonable estimate of a liability, if any. As additional information becomes available, we adjust our assessment and estimates of such labilities accordingly.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following section should be read in conjunction with our Condensed Consolidated Financial Statements and related Notes appearing in this Form 10-Q. With the exception of statements regarding historical matters and statements concerning our current status, certain matters discussed in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” are forward-looking statements that involve substantial risks and uncertainties. Such forward-looking statements may be identified by the words “anticipate,” “believe,” “estimate,” “expect” or “intend” and similar expressions. Our actual results, performance or achievements could differ materially from these forward-looking statements.
Factors that could cause or contribute to such material differences include internal control weaknesses, impact of changes in estimates on fixed price projects, variability of operating results, failure to recruit, train and retain skilled Information Technology (“IT”) professionals, exposure to regulatory, political and general economic conditions in India and Asia, short term nature and termination provisions of contracts, competition in the IT services industry, economic conditions unique to clients in specific industries, the success of the company to negotiate contract renewals at comparable terms, decline in profitability of European operations, public sector budget constraints, limited protection of intellectual property rights, foreign exchange fluctuation, and risks related to merger, acquisition and strategic investment strategy.
Overview
We are a global technology services company, with a focus on industry-specific solutions, strategic outsourcing and integration solutions. We address the most challenging technology issues companies are facing through an onsite, offsite, offshore delivery model that helps clients achieve rapid deployment and reduced costs. We offer high-level subject matter expertise in the public sector industry, as well as years of experience in retail, healthcare, distribution, manufacturing, financial services, telecommunications and utilities. We apply our industry-specific knowledge to deliver a wide range of outsourcing and integration services, including: application maintenance and development outsourcing (AMD/O); custom application development; e-business services; packaged software implementation, upgrades and enhancements; and other services. Our strategy is to establish long-term client relationships and to secure additional engagements with existing clients by providing quality services and by being responsive to client needs.
We generally assume responsibility for project management and may bill the client on either a time-and-materials or fixed-price basis. We recognize revenue on time-and-materials engagements as the services are performed. On fixed-price engagements, we recognize revenue under the percentage of completion method except for fixed-price outsourcing contracts where we recognize revenue ratably over the applicable period. For the three month periods ended September 30, 2005 and 2004, approximately 43.0% and 41.0%, respectively, of our total revenue was generated from fixed-price engagements.
Our most significant cost is project personnel cost, which consists primarily of salaries, wages and benefits for our IT professionals. We strive to maintain our gross profit margin by controlling project costs and managing salaries and benefits relative to billing rates. We use a human resource management team to ensure that IT professionals are quickly placed on assignments to minimize nonbillable time and are placed on assignments that use their technical skills and allow for maximum billing rates.
In an effort to sustain our growth and profitability, we have made and continue to make investments in our infrastructure, including: (1) development centers in the United States and India; (2) system methodologies; and (3) internal systems.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenue and expenses and related disclosures in the consolidated financial statements and accompanying notes. We regularly evaluate and discuss with our Audit Committee the accounting policies and estimates we use to prepare our consolidated financial statements. Estimates are used for, but not limited to,
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revenue recognition under the percentage-of-completion method, impairment assessments of goodwill and other long-lived assets, realization of deferred tax assets and other tax-related contingencies, allowance for doubtful accounts, and litigation related contingencies. These estimates are based on historical experience, project management, and various assumptions that we believe to be reasonable given the particular facts and circumstances. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results could differ significantly from these estimates under different assumptions, judgments or conditions.
The Securities and Exchange Commission has defined “critical accounting policies” as those that are most important to the portrayal of a company’s financial condition and results of operations, and which require the Company to make its most difficult and subjective judgments, often as a result of the need to make estimates. Based on this definition, we have identified the critical accounting policies discussed below. We have other significant accounting policies, which also involve the use of estimates, judgments and assumptions that are integral to understanding our results of operations. For a complete discussion of all significant accounting policies, see Note 1 of our Notes to Consolidated Financial Statements included in our 2004 Form 10-K.
The following is an overview discussion of our critical accounting policies.
Revenue Recognition. We recognize revenue in accordance with Staff Accounting Bulletin No. 104, for our time-and-materials and fixed price outsourcing contracts. For those service contracts which are billed on a time and materials basis, we recognize revenue as the services are performed. In our time and materials contracts our effort, measured by our time incurred, represents the contractual milestones or output measure which is the contractual earnings pattern. For our fixed price IT outsourcing and maintenance contracts, we recognize revenue ratably over the applicable outsourcing or maintenance period as the services are performed continuously over the contract period.
For our contracts to design, develop or modify complex information systems based upon the client’s specifications, we recognize revenue on a percentage of completion basis in accordance with Statement of Position 81-1. The percentage of completion is determined by relating the actual cost of labor performed to date to the estimated total cost of labor for each contract. This method is followed where reasonably dependable estimates of revenue and cost can be made. Estimates of total contract revenue and cost are continuously monitored during the term of the contract, and recorded revenue and cost are subject to revision as the contract progresses. Such revisions, which may result in increases or decreases to revenue and income, are reflected in the financial statements in the period in which they are first identified. If the estimate indicates a loss on a particular contract, a provision is made for the entire estimated loss without reference to the percentage of completion.
Covansys periodically enters into contracts that include multiple-element arrangements, which may include any combination of services, software, support/maintenance, and the re-sale of hardware or software. Contracts entered into after June 30, 2003 containing multiple elements or deliverables are segmented into separate units of accounting where the separate elements represent separate earnings processes in accordance with EITF 00-21. Revenues are allocated among the elements based on the relative fair values of the elements and are recognized in accordance with our policies for the separate elements unless the undelivered elements are essential to the functionality of the delivered elements. In circumstances where an undelivered element is essential to the functionality of the delivered element, no revenue is recognized for the delivered element until the undelivered element is delivered.
Retainages, which are not material for any of the periods presented, are included in revenue earned in excess of billings in the accompanying condensed consolidated balance sheets. Revenue earned in excess of billings is primarily comprised of revenue recognized on certain contracts in excess of contractual billings on such contracts.
Impairment of Long-Lived Assets.We review the recoverability of our long-lived assets, including property and equipment when events or changes in circumstances occur that indicate that the carrying value of the asset may not be recoverable and goodwill at least annually. The assessment of possible impairment is
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based on our ability to recover the carrying value of the asset from expected future pre-tax cash flows of the related asset group or operating segment. If these cash flows are less than the carrying value of such asset, an impairment loss is recognized for the difference between estimated fair value and carrying value. The measurement of impairment requires management to make estimates of these cash flows related to long-lived assets, as well as other fair value determinations.
Computer Software. We perform research to develop software for various business applications. The costs of such research are charged to expense when incurred. When the technological feasibility of the product is established, subsequent costs are capitalized. Capitalized software costs are amortized on a product-by-product basis. Amortization is recorded on the straight-line method over the estimated economic life of the product, generally five years, commencing when such product is available. The establishment of technological feasibility and the ongoing assessment of the recoverability of these costs requires considerable judgment by management with respect to certain external factors including, but not limited to, anticipated future gross product revenue, estimated economic product lives and changes in software and hardware technology. These assumptions are reevaluated and adjusted as necessary at the end of each accounting period. Management reviews the valuation and amortization of capitalized development costs. We periodically consider the value of future cash flows attributable to the capitalized development costs in evaluating potential impairment of the asset. Amounts charged to expense for research and development of computer software were not material in the periods indicated.
Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Realization of deferred tax assets associated with the Company’s future deductible temporary differences and net operating loss carryforwards is dependent upon generating sufficient taxable income prior to their expiration. Although realization of the deferred tax assets is not assured, management believes it is more likely than not that the deferred tax assets will be realized through future taxable income. On a quarterly basis, management assesses whether it remains more likely than not that the deferred tax assets will be realized.
Liquidity and Capital Resources
As of September 30, 2005, the Company had cash and short-term investments of $67.3 million. The Company funds its operations and working capital needs through internally generated funds. Cash provided from operations in the first nine months of 2005 was $27.6 million which included the use of cash for working capital of $11.0 million.
Investing activities used $4.7 million in cash during the first nine months of 2005 for the acquisition of Fortune Infotech and capital expenditures, partially offset by net cash receipts from the sale and purchase of short-term securities.
To facilitate future cash flow needs, the Company has a credit facility which provides for borrowings or standby and commercial letters of credit up to $30.0 million through December 28, 2005.
The Credit Agreement contains financial covenants which require the Company to maintain a certain interest coverage ratio, leverage ratio and a minimum total capitalization. At September 30, 2005, the Company was in compliance with these ratios. At September 30, 2005, the Company had no borrowings and $9.4 million in outstanding letters of credit under this Credit Agreement.
Financing activities used $19.4 million in cash for the repayment of outstanding subordinated notes and the repurchase of approximately 403,000 shares of the Company’s common stock, partially offset by proceeds from the exercise of stock options.
The Company has no off-balance sheet transactions.
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Results of Operations
Revenue and gross profit by segment is as follows:
| Three Months Ended | Nine Months Ended | |||||||||||||||||
| September 30, | September 30, | |||||||||||||||||
| 2005 | 2004 | 2005 | 2004 | |||||||||||||||
| Revenue | ||||||||||||||||||
| Commercial | $ | 66,251 | $ | 59,176 | $ | 192,060 | $ | 175,647 | ||||||||||
| Less intersegment | (2,302 | ) | (156 | ) | (5,864 | ) | (520 | ) | ||||||||||
| 63,949 | 59,020 | 186,196 | 175,127 | |||||||||||||||
| Public Sector | 27,628 | 24,235 | 83,065 | 69,797 | ||||||||||||||
| India/Asia | 42,535 | 33,647 | 120,130 | 88,401 | ||||||||||||||
| Less intersegment | (22,934 | ) | (20,701 | ) | (65,232 | ) | (58,122 | ) | ||||||||||
| 19,601 | 12,946 | 54,898 | 30,279 | |||||||||||||||
| $ | 111,178 | $ | 96,201 | $ | 324,159 | $ | 275,203 | |||||||||||
| Gross profit (loss) | ||||||||||||||||||
| Commercial | $ | 18,545 | $ | 16,195 | $ | 55,999 | $ | 46,834 | ||||||||||
| Public Sector | 3,930 | 4,676 | 16,138 | 8,538 | ||||||||||||||
| India/Asia | 7,400 | 5,807 | 19,869 | 12,559 | ||||||||||||||
| Other | (879 | ) | (562 | ) | (2,280 | ) | (1,659 | ) | ||||||||||
| $ | 28,996 | $ | 26,116 | $ | 89,726 | $ | 66,272 | |||||||||||
Revenue. Revenue was $111.2 million and $96.2 million in the third quarter of 2005 and 2004 and $324.2 million and $275.2 million for the nine months ended September 30, 2005 and 2004, respectively. Revenue from the commercial segment in the third quarter of 2005 was $63.9 million, on an increase of 8.4% over 2004 revenue of $59.0 million. For the nine months ended September 30, 2005, commercial revenue was $186.2 million, a 6.3% increase over 2004 revenue of $175.1. The increase in revenue is due principally to increased penetration within the Company’s historical customer base. During the fourth quarter of 2004, the Company continued to perform services for one of its significant customers after it had reached the authorized spending limit on a time and material contract. While the Company believed it would be paid for these services, management concluded that it did not have a legally enforceable contractual right to the revenue at December 31, 2004. As a result, in accordance with the Company’s revenue recognition policies and Staff Accounting Bulletin 104, the Company recognized the costs for these services but did not recognize any revenue for these services in the fourth quarter of 2004, which negatively impacted fourth quarter 2004 revenue and gross profit by approximately $3.5 million. In the first quarter of 2005, the Company received the contract which covered these services and recognized the revenue with a corresponding increase in gross profit.
Public sector revenue increased $3.4 million from third quarter revenue of $24.2 million in 2004 and increased $13.3 million from the first nine months revenue of $69.8 million in 2004. Much of the increase in both periods is due to new projects and higher levels of hardware and software sales. Adjustments to the estimated cost to complete on certain fixed price contracts in the first nine months of 2004 in respect of which the Company recognizes income on the percentage of completion basis resulted in the Company not recognizing approximately $4.8 million of revenue in the nine months ended September 30, 2004 which would have been recognized had the estimates to complete not required adjustment. In addition, public sector revenue was also negatively impacted during 2004 by a $5.9 million adjustment related to management’s reassessment of the collectibility of outstanding billed and unbilled receivables associated with two troubled projects. In accordance with the application of percentage of completion accounting, the Company reflected the changes as a contract price adjustment, and accordingly, as a reduction in revenue.
Revenue from India/Asia increased significantly in both periods over the comparable periods in 2004, reflecting the shift to a higher utilization of Indian resources on existing customer relationships, transfer of
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certain commercial segment customer relationships to the region as well as increased revenue from the Company’s Master Services Agreement with FIS which commenced in the second quarter of 2004.
On May 3, 2005, Oracle announced that it has exercised its purchase option to acquire PeopleSoft’s development center in Bangalore, India operated by the Company. The transfer of this center is expected to be completed in November 2005, upon which the employees of the center (approximately 500 at September 30, 2005) will become employees of Oracle. Revenue generated from this development center for the Company was approximately $8.4 million, $4.0 million and $12.1 million for the year ended December 31, 2004 and the three and nine months ended September 30, 2005, respectively. Under terms of the agreement, Oracle will pay a buyout fee of approximately $1.2 million, and an amount equal to the book value of the net assets related to this business.
Gross Profit. Gross profit in the third quarter of 2005 was $29.0 million or 26.1% of revenue compared with $26.1 million or 27.1% of revenue in the comparable 2004 period. Gross profit for the first nine months of 2005 was $89.7 million or 27.7% of revenue compared with a 66.3 million or 24.1% of revenue in 2004. Gross profit in the third quarter of 2005 was negatively impacted by lower margins in public sector as well as lower pricing and other concessions on certain commercial segment customers. Effective April 1, 2005, the Company also adjusted intercompany transfer prices for services rendered by India. The result was to increase India/Asia segment gross margins by $1.4 million and $2.9 million in the third quarter and first nine months of 2005, with a reduction in commercial segment and public sector segment gross margins of $1.3 million and $.1 million in the third quarter of 2005, respectively and $2.6 million and $.3 million for the first nine months of 2005, respectively. Commercial gross profit was $18.5 million and $56.0 million or 29.0% and 30% of revenue for the three months and nine months ended September 30, 2005 compared with $16.2 million and $46.8 million or 27.4% and 26.7% for the three and nine months ended September 30, 2004. The improvement in part is due to additional work performed by resources in India, partially offset by lower pricing and other concessions on certain commercial segment customers as well as the change in intercompany transfer pricing discussed above. In addition during the fourth quarter of 2004, the Company continued to perform services for one of its significant customers after it had reached the authorized spending limit on a time and material contract. While the Company believed it would be paid for its services, management concluded that it did not have a legally enforceable contractual right to the revenue as of December 31, 2004. As a result, in accordance with the Company’s revenue recognition policies and Staff Accounting Bulletin 104, the Company recognized the costs for these services in the fourth quarter of 2004, but did not recognize the related revenue. Gross profit was negatively impacted in the fourth quarter of 2004 by approximately $3.5 million. In the first quarter of 2005, the Company received a contract which covered these services and recognized the revenue in the first quarter of 2005, with a corresponding impact in gross profit.
Gross profit for the first nine months of 2004 was negatively impacted by the reassessment of costs of a loss contract, adjustments to estimates to the costs to complete for certain public sector contracts, as well as the adjustment of certain unbilled fixed price contract receivables in the public sector segment based on perceived collection risk. These adjustments had a negative impact of approximately $1.3 million and $10.7 million in the three months and nine months ended September 30, 2005. Gross profit for the three months and nine months ended September 30, 2005 was impacted by higher revenue from hardware and software sales which carry a lower overall gross profit than revenue from consulting services. In addition, certain projects accounted for on the percentage completion basis had adjustments to the estimated costs to complete the project which also had a negative impact on margins.
India/Asia gross profit increased in both periods due to higher levels of activity including additional revenue from the Master Services Agreement signed with FIS in the second quarter of 2004. In addition, gross profit increased as a result of the adjustment of intercompany transfer prices as discussed above.
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $17.7 million and $16.9 million in the third quarter of 2005 and 2004, respectively or 15.9% and 17.6% of revenue. For the nine months ended September 30, 2005 and 2004, selling, general and administrative expenses were $54.7 million and $55.8 million respectively or 16.9% and 20.3% of revenue. Included in 2005 are higher costs for professional fees related to consultation and internal auditing for the implementation of Sarbanes-Oxley Section 404 and higher costs associated with the restatement of prior year financial
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statements. Also included in this period is a $.3 charge for lease termination. See the Company’s 2004 Annual Report on Form 10-K for additional information surrounding the restatement. Included in selling, general and administrative costs in the third quarter of 2004 are executive severance costs of $.6 million and $.7 million in professional fees associated with the fixed asset analysis and $.4 million in professional service fees associated with the FIS/CDR transaction. In addition, the first nine months of 2004 includes $1.2 million in lease termination costs, $.7 million in professional fees associated with the fixed asset analysis and a charge of $1.0 million from the loss on disposal and obsolescence of property and equipment as further described in Note 7.
Interest Expense. Interest expense was $.5 million in the nine months ended September 30, 2005 related to the $17.5 million in senior subordinated notes issued in connection with the FIS/CDR transaction (Note 2) and fees in connection with a credit agreement (Note 12). The senior subordinated notes were repaid in July 2005.
Other Income, Net. Other income, net represents interest earned and realized gains and losses from the sale of short-term investments and cash equivalents and foreign currency transaction and translation gains and losses.
Provision for Income Taxes. The effective tax rate in the third quarter and first nine months of 2005 was 27.9% and 22.5%, respectively. The tax rate in the third quarter was impacted by the reversal of previously recorded valuation allowances of $.4 million that were no longer required. In addition, the nine month tax rate was impacted by the reversal of previously recorded tax reserves of $3.2 million due to the expiration of the statute of limitations for the tax years the reserves related to as well as a charge of $.5 million for the reversal of deferred tax assets due to an enacted law change in the State of Ohio which will reduce the amount of net operating losses that the Company will be able to utilize in future periods.
Recently Issued Financial Accounting Standards
In December 2004 the FASB issued FAS 123R, “Share-Based Payment,” that requires companies to expense the value of employee stock options and similar awards. The effective date for application by public companies is annual periods beginning after June 15, 2005. FAS 123R applies to all outstanding and unvested share-based payment awards at a company’s adoption date. FAS 123R allows alternative transition methods. The Company has not yet selected a transition method. Management is presently reviewing the impact on our results of operation and financial position from implementing FAS 123R.
In December 2004, the FASB issued a FASB Staff Position (FSP) 109-2 “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Program within the American Jobs Creation Act of 2004”, which provides accounting and disclosure guidance for the foreign earnings repatriation provision within the American Jobs Creation Act of 2004. The Act provides special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer. FSP FASB 109-2 provides for a period of time beyond the financial reporting period of enactment for a company to evaluate the effect of the Act on its plan for reinvestment or repatriation of foreign earnings. The Company is in the process of evaluating the one-time repatriation opportunities provided by the Act. At the time of filing these statements, the Company cannot reasonably estimate the income tax effects of such repatriation under the Act.
In May 2005, the FASB issued FAS 154, “Accounting Changes and Error Corrections”, a replacement of APB Opinion No. 20 and FASB Statement No. 3. Previously, APB No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements” required the inclusion of the cumulative effect of changes in accounting principle in net income of the period of the change. FAS 154 requires companies to recognize changes in accounting principle, including changes required by a new accounting pronouncement when the pronouncement does not include specific transition provisions, retrospectively to prior periods’ financial statements, unless impracticable to determine the effects of the change. The effective date for application by public companies is annual periods beginning after December 15, 2005. The Company will assess the impact of a retrospective application of a change in accounting principle in accordance with FAS 154 if the need for such a change arises after the effective date.
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Commitments, Contingencies and Potential Liability to Clients
The Company is, from time to time, party to ordinary, routine tax and legal proceedings, claims and litigation incidental to the Company’s business, including potential claims relating to tax liabilities for employees of foreign subsidiaries. After discussion with its tax and legal counsel, the Company does not believe that the ultimate resolution of any existing matter will have a material adverse effect on its financial condition, results of operations or cash flows.
In addition, many of the Company’s engagements involve projects that are critical to the operations of its clients’ businesses and provide benefits that may be difficult to quantify. The Company attempts to contractually limit its liability for damages arising from errors, mistakes, omissions or negligent acts in rendering its services. The Company has undertaken engagements for which the Company guarantees its performance based upon defined client specifications on delivery dates. Certain engagements have required the Company to obtain a performance bond from a licensed surety, to guarantee performance, and to post the performance bond with the client. The Company intends to satisfy all of its performance obligations with its clients and does not anticipate defaulting on any of these performance bonds or letters of credit.
Available Information
Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, proxy statements and amendments to those reports, are available free of charge on our internet website at http://www.covansys.com as soon as reasonably practicable after such reports are electronically filed with the Securities and Exchange Commission.
| Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
We are exposed to market risk for the effect of foreign currency fluctuations and interest rate changes. Information relating to quantitative and qualitative disclosure about market risk is set forth below and in Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.
| Foreign Exchange Risk |
Foreign currency fluctuations during the nine months ended September 30, 2005 and 2004 resulted in a translation gain (loss) of approximately $23 and $(139), respectively, from the remeasurement of nonfunctional currency net asset positions into the functional currency of the respective foreign subsidiary. The Company may use derivatives from time to time to hedge against foreign currency fluctuations. The Company had no outstanding derivative position as of September 30, 2005 or December 31, 2004. The Company does not speculate in foreign currency.
| Interest Rate Risk |
Our exposure to market risk for changes in interest rates relates primarily to our cash and short-term investment portfolio, which was $67.3 million as of September 30, 2005. All of our short-term investments are designated as available-for-sale and, accordingly, are presented at fair value in the consolidated balance sheet. A portion of our short term investments are in mutual funds. Mutual funds may have their fair market value adversely affected due to a rise in interest rates, and we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates.
| Item 4. | Controls and Procedures |
Disclosure Controls and Procedures
The Company maintains controls and procedures designed to ensure that it is able to collect the information that is required to be disclosed in the reports it files with the SEC, and to process, summarize and
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disclose this information within the time period specified by the rules of the SEC. The Company’s Chief Executive Officer and the Chief Financial Officer are responsible for establishing, maintaining and enhancing these controls and procedures. Based on their evaluation of the Company’s disclosure controls and procedures as of September 30, 2005 the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were not effective for the reasons discussed below.
Changes in Internal Controls
The Company’s internal control over financial reporting is the responsibility of the Chief Executive Officer and the Chief Financial Officer. To fulfill this responsibility, management has continued to enhance internal controls and increase the oversight over those affected controls. Management has also taken corrective action with regard to identified significant deficiencies and material weaknesses through a number of initiatives including those specifically set forth below.
Revenue Contract Accounting.In the first quarter of 2005, the Company engaged in a thorough process to organize and catalogue its customer contracts in preparation of the integration of its contract information into a module of its ERP system. This process confirmed that measures implemented by the Company at the end of the second quarter of 2004 had strengthened the Company’s revenue recognition processes by requiring that contract documentation for new engagements be presented to and/or confirmed by the Legal Department prior to recognition of revenue for that contract. There are still improvements required, however, to strengthen the design of the Company’s process to capture and validate the contractual terms which impact the Company’s recognition of revenue. In conjunction with the contract organization process and in preparation of the year-end consolidated financial statements, management reviewed substantially all of its contracts that contain a fee limitation cap to confirm that revenue recognized did not exceed the fee limitation cap. It was through this process that the revenue adjustment associated with the contract disclosed in Note 22 of the consolidated financial statements in the 2004 Form 10-K, was identified and recorded during the fourth quarter closing process. The Company is continuing to develop procedures to improve the flow of information between its legal, finance and field operations, which procedures will include:
| • | Quarterly verification that contractual documentation exists to support revenue recognized in the applicable reporting period; | |
| • | Integration of the Company’s contract repository into a module of the Company’s ERP system; and | |
| • | Enhancement of the Company’s ERP system to track fee limitation caps. |
Percentage of Completion Accounting.In November 2003, the Company disclosed a material weakness in its internal controls related to the Company’s application of the percentage-of-completion method of accounting for its fixed price contracts. The Company has implemented a multi-part plan to strengthen controls of fixed price contracts and to enhance the processes supporting application of the percentage-of-completion method of accounting for its fixed price contracts. As of December 31, 2004, however, management concluded that the material weakness had not been adequately remediated. Specifically, management determined that the initiatives encompassed in that plan had not been fully implemented and were not yet operating effectively. Since the material weakness was identified in 2003, management has implemented the following:
| • | Standardization and continuous improvement of the use of three primary estimating tools; | |
| • | Periodic project reviews with executive management; | |
| • | Enhanced training addressing revenue recognition, contract management and project tracking and reporting. Migration of project plans and project reporting to a standard workbook; | |
| • | The addition of a fixed price specialist to assist the project management teams on use of the standard workbook along with being available to address project related reporting issues; and | |
| • | Monthly certification by individual project managers attesting to the appropriateness of their monthly estimate-to-complete submissions. |
The Company believes the foregoing measures strengthened its accounting policies with regard to percentage-of-completion accounting, but that such measures did not include a consistent risk-adjusted
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methodology for project managers to use in their estimates of costs to complete on percentage of completion projects. The Company will continue to strengthen its processes in this area in 2005 through:
| • | Creation and consistent application of a risk-adjusted methodology to identify the appropriate level of contingency for percentage of completion projects and a framework for project managers to use in calculating their estimates of costs to complete; | |
| • | Continued executive oversight of significant projects including weekly reviews by executive management of projects that include new or high risk technology implementations or that have significantly deviated from the project plan; | |
| • | Increased monitoring of projects by the Project Management Office; | |
| • | Creation of more detailed procedural documentation and additional training to assist the Company’s employees in their reporting responsibilities; and | |
| • | Automation and integration of the Company’s various systems and spreadsheets to provide greater transparency and real time information about the various projects and contracts under which the Company operates. |
Net Property and Equipment:At the conclusion of a physical inventory process undertaken by the Company in June 2004, the Company identified a charge of $2.6 million for assets that could not be located or were no longer in use. This process resulted in a restatement of previously issued financial statements for 2003, 2002, and 2001 and in the Company reporting a material weakness related to the Company’s recording and tracking of fixed assets in its Form 10-Q for the quarter ended March 31, 2004. Additionally, as part of the year-end closing process, management discovered that a consolidating entry to properly record inter-company property and equipment transactions on the balance sheet at December 31, 2003, and at quarterly balance sheets through September 30, 2004, was classified within accumulated comprehensive income in error. This balance sheet misclassification has been corrected in the financial statements for the prior period. Since June 2004, the Company has successfully accomplished the following items of its plan to strengthen accounting for its fixed assets:
| • | Development of a policy and procedure manual regarding the recording, tracking and depreciation of fixed assets; | |
| • | Addition of a new resource in the information technology staff who is responsible for equipment tracking; | |
| • | Periodic physical inventories of fixed assets including one completed at year-end 2004 which resulted in no material subsequent adjustments. Management will continue the periodic physical inventory process in 2005; and | |
| • | Implementation of a transaction level fixed asset module within the Company’s ERP system to integrate the tracking of its fixed assets. |
Income Taxes:As part of its 2004 year-end closing process, the Company identified errors when reconciling its cumulative temporary difference and contingent tax liabilities to recorded amounts. Management has strengthened controls over this area in 2005 by enlisting additional tax expertise through more effective use and oversight of a third party tax service provider.
Leases (Step-Rents):As part of its 2004 year-end closing process, it was concluded that straight-line rent expense for the Company’s headquarters had been incorrectly accrued and that the related lease expense for prior periods was incorrect. This error was determined to be a material weakness in internal controls and resulted in a restatement of prior period financial statements. The Company has recently implemented controls to reduce the risk of such an error in the future through implementation of a comprehensive lease review checklist, review of each significant lease for proper accounting treatment by the Company’s Finance Department, and limiting execution of all property leases by the Company’s Chief Financial Officer or authorized designee.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
As previously disclosed, the Company’s prior independent registered public accounting firm has notified the Company that it received a letter from the Securities and Exchange Commission (“SEC”) dated October 22, 2004 requesting certain information about the Company relating to the period January 1, 2001 to the present. On April 14, 2005, the Company received a subpoena for the production of documents from the Midwest Regional Office of the SEC regarding an investigation the SEC has commenced captioned In the matter of Covansys Corp. (C-03825). The Company is cooperating to the fullest extent possible in the production of the requested documents.
On April 8, 2005, Covansys received service of a lawsuit captioned Leon S. Segen, derivatively on behalf of Covansys Corporation versus CDR-Cookie Acquisition, L.L.C., Clayton, Dubilier & Rice Fund VI Limited Partnership, CD&R Associates VI Limited Partnership, CD&R Investment Associates VI, Inc., and Covansys Corporation. The case is filed in the U.S. Southern District court for the Southern District of New York case no. 05CV3509. The derivative claim seeks recovery under Section 16(b) of the Securities and Exchange Act of 1934 to obtain disgorgement of profits of CD&R related to the recapitalization transaction consummated with the CD&R entities in September 2004. The Company is monitoring developments in the matter with legal counsel.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
| (a) | The Company did not sell any unregistered securities during the quarter ended September 30, 2005. | |
| (c) | Repurchases of Company Stock |
The Company has a previously disclosed stock repurchase plan. During the quarter ended September 30, 2005 the Company had the following activity:
| (d) | ||||||||||||||||
| Maximum Number | ||||||||||||||||
| (c) | (or Approximate | |||||||||||||||
| Total Number of | Dollar Value) of | |||||||||||||||
| (a) | Shares (or Units) | Shares (or Units) | ||||||||||||||
| Total Number of | (b) | Purchased as Part of | that May Yet Be | |||||||||||||
| Shares (or Units) | Average Price Paid | Publicly Announced | Purchased Under the | |||||||||||||
| Period | Purchased | per Share (or Unit) | Plans or Programs | Plans or Programs | ||||||||||||
| July 2005 | — | — | — | 2,161,824 | ||||||||||||
| August 2005 | — | — | — | 2,161,824 | ||||||||||||
| September 2005 | — | — | — | 2,161,824 | ||||||||||||
Item 6. Exhibits
(a) Exhibits
| Number | Exhibit | |||
| 31.1 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |||
| 31.2 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |||
| 32.1 | Certification of Rajendra B. Vattikuti pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |||
| 32.2 | Certification of James S. Trouba pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |||
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| COVANSYS CORPORATION |
| By: | /s/Thomas E. Lindsey |
| Thomas E. Lindsey | |
| Vice President and Chief | |
| Accounting Officer | |
| (Principal Accounting Officer) | |
| /s/James S. Trouba | |
| James S. Trouba | |
| Vice President and | |
| Chief Financial Officer | |
| (Principal Financial Officer) |
Dated: October 27, 2005
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Exhibit Index
| Exhibit No. | Description | |||
| 31.1 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |||
| 31.2 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |||
| 32.1 | Certification of Rajendra B. Vattikuti pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |||
| 32.2 | Certification of James S. Trouba pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |||