UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2005
or
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 0-22010
THOMAS GROUP, INC.
(Exact name of registrant as specified in its charter)
Delaware |
| 72-0843540 |
(State or other jurisdiction of |
| (I.R.S. Employer |
5221 North O’Connor Boulevard
Suite 500
Irving, TX 75039-3714
(Address of principal executive offices, including zip code)
(972) 869-3400
(Registrant’s telephone number, including area code)
NONE
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes o No x
As of November 10, 2005 there were 10,655,143 shares of the registrant’s common stock outstanding.
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PART I—FINANCIAL INFORMATION |
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Consolidated Balance Sheets at September 30, 2005 and December 31, 2004 |
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Consolidated Statements of Cash Flows for the Nine Month Periods Ended September 30, 2005 and 2004 |
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Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations. |
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Item 3—Quantitative and Qualitative Disclosures About Market Risk |
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PART II—OTHER INFORMATION |
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2
THOMAS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands)
|
| September 30, |
| December 31, |
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| (unaudited) |
| (audited) |
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ASSETS |
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Current Assets |
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Cash and cash equivalents |
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| $ | 2,515 |
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| $ | 143 |
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Trade accounts receivable, net of allowances of $137 and $114 at September 30, 2005 and December 31, 2004, respectively |
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| 7,531 |
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| 5,161 |
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Other current assets |
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| 376 |
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| 415 |
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Total Current Assets |
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| 10,422 |
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| 5,719 |
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Property and equipment, net of accumulated depreciation of $7,791 and $7,575 in 2005 and 2004, respectively |
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| 545 |
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| 694 |
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Other assets |
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| 91 |
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| 136 |
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| $ | 11,058 |
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| $ | 6,549 |
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LIABILITIES AND STOCKHOLDERS’ EQUITY |
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Current Liabilities |
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Accounts payable and accrued liabilities |
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| $ | 1,045 |
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| $ | 936 |
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Accrued wages and benefits |
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| 2,342 |
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| 1,232 |
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Income taxes payable |
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| 195 |
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| 108 |
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Revolving line of credit |
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| — |
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| 430 |
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Current maturities of other long-term obligations |
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| 6 |
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| 6 |
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Total Current Liabilities |
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| 3,588 |
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| 2,712 |
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Indebtedness to related parties |
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| — |
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| 1,400 |
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Other long-term obligations |
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| 333 |
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| 6 |
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Total Liabilities |
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| 3,921 |
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| 4,118 |
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Commitments and Contingencies |
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Stockholders’ Equity |
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Common stock, $.01 par value; 25,000,000 shares authorized; 13,209,019 and 12,241,822 shares issued and 10,655,143 and 9,687,946 shares outstanding at September 30, 2005 and December 31, 2004, respectively |
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| $ | 132 |
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| $ | 122 |
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Additional paid-in capital |
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| 26,401 |
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| 26,238 |
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Retained earnings (accumulated deficit) |
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| 3,745 |
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| (788 | ) |
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Accumulated other comprehensive loss |
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| (682 | ) |
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| (682 | ) |
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Treasury stock, 2,553,876 shares at September 30, 2005 and December 31, 2004, respectively, at cost |
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| (22,459 | ) |
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| (22,459 | ) |
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Total Stockholders’ Equity |
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| 7,137 |
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| 2,431 |
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| $ | 11,058 |
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| $ | 6,549 |
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See accompanying notes to consolidated financial statements.
3
THOMAS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
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| Three Months |
| Nine Months |
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| 2005 |
| 2004 |
| 2005 |
| 2004 |
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Consulting revenue before reimbursements |
| $ | 11,763 |
| $ | 7,277 |
| $ | 31,333 |
| $ | 22,063 |
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Reimbursements |
| 23 |
| 9 |
| 29 |
| 91 |
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Total revenue |
| 11,786 |
| 7,286 |
| 31,362 |
| 22,154 |
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Cost of sales before reimbursable expenses |
| 5,210 |
| 3,684 |
| 14,284 |
| 11,330 |
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Reimbursable expenses |
| 23 |
| 9 |
| 29 |
| 91 |
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Total cost of sales |
| 5,233 |
| 3,693 |
| 14,313 |
| 11,421 |
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Gross profit |
| 6,553 |
| 3,593 |
| 17,049 |
| 10,733 |
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Selling, general and administrative |
| 3,822 |
| 3,250 |
| 10,530 |
| 9,653 |
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Sublease losses |
| — |
| — |
| 610 |
| — |
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Operating income |
| 2,731 |
| 343 |
| 5,909 |
| 1,080 |
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Other income (expense), net |
| 21 |
| (65 | ) | (49 | ) | (239 | ) | ||||
Income before income taxes |
| 2,752 |
| 278 |
| 5,860 |
| 841 |
| ||||
Income taxes |
| 89 |
| 15 |
| 190 |
| 16 |
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Net income |
| $ | 2,663 |
| $ | 263 |
| $ | 5,670 |
| $ | 825 |
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Earnings per common share: |
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Basic |
| $ | 0.25 |
| $ | 0.03 |
| $ | 0.54 |
| $ | 0.09 |
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Diluted |
| $ | 0.25 |
| $ | 0.02 |
| $ | 0.53 |
| $ | 0.08 |
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Weighted average shares: |
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Basic |
| 10,655 |
| 9,665 |
| 10,465 |
| 9,648 |
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Diluted |
| 10,784 |
| 10,529 |
| 10,649 |
| 10,559 |
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See accompanying notes to consolidated financial statements.
4
THOMAS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
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| For the Nine Months |
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| 2005 |
| 2004 |
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Cash Flows From Operating Activities: |
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Net Income |
| $ | 5,670 |
| $ | 825 |
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Adjustments to reconcile net income to net cash provided by operating activities: |
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Depreciation |
| 217 |
| 351 |
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Amortization |
| 14 |
| 14 |
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Loss on subleases |
| 510 |
| — |
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Bad debt |
| 30 |
| — |
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Amortization (cancellation) of stock option grants |
| (11 | ) | 100 |
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Other |
| 167 |
| (28 | ) | ||
Change in operating assets and liabilities: |
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Increase in trade accounts receivable |
| (2,389 | ) | (1,787 | ) | ||
(Increase) decrease in unbilled receivables |
| (10 | ) | 295 |
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(Increase) decrease in other assets |
| 67 |
| (198 | ) | ||
Increase in accounts payable and accrued liabilities |
| 1,145 |
| 535 |
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Decrease in other liabilities |
| (267 | ) | — |
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Increase (decrease) in income taxes payable |
| 86 |
| (57 | ) | ||
Net cash provided by operating activities |
| 5,229 |
| 50 |
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Cash Flows From Investing Activities: |
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Proceeds from sale of assets |
| 1 |
| — |
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Capital expenditures |
| (76 | ) | (24 | ) | ||
Net cash used in investing activities |
| (75 | ) | (24 | ) | ||
Cash Flows From Financing Activities: |
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Issuance of common stock |
| 10 |
| 1 |
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Proceeds from exercise of stock options |
| 35 |
| 51 |
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Proceeds from exercise of stock warrants |
| 252 |
| — |
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Repurchase of stock warrants |
| (1,250 | ) | — |
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Cash overdraft |
| — |
| 45 |
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Repayments of related party indebtedness |
| (1,400 | ) | — |
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Repayments of debt and other long-term obligations |
| (3 | ) | (2,805 | ) | ||
Net advances (repayments)—line of credit |
| (430 | ) | 758 |
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Net cash used in financing activities |
| (2,786 | ) | (1,950 | ) | ||
Effect of exchange rate changes on cash |
| 4 |
| — |
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Net change in cash |
| 2,372 |
| (1,924 | ) | ||
Cash and cash equivalents |
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Beginning of period |
| 143 |
| 1,924 |
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End of period |
| $ | 2,515 |
| $ | — |
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See accompanying notes to consolidated financial statements.
5
THOMAS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Summary of Significant Accounting Policies
(a) Basis of Presentation—The unaudited consolidated financial statements of Thomas Group, Inc. (the “Company”) include all adjustments, which include only normal recurring adjustments, which are, in the opinion of management, necessary to present fairly the results of operations of the Company for the interim periods presented. The unaudited financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Company’s Form 10-K for the 2004 fiscal year, filed with the Securities and Exchange Commission. The results of operations for the three and nine month periods ended September 30, 2005 are not necessarily indicative of the results of operations for the entire year ending December 31, 2005. Certain amounts from prior periods have been reclassified to conform to the 2005 presentation.
(b) Stock Based Compensation—On December 16, 2004, the FASB issued SFAS No. 123(R), “Share-based Payments”, which addresses the accounting for employee services received in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123(R) was originally scheduled to be effective as of the beginning of the first interim or annual reporting period that begins after June 15, 2005 for public entities that do not file as small business issuers. On April 14, 2005, the SEC announced the adoption of a new rule amending the compliance date to the beginning of the first annual reporting period that begins after June 15, 2005 for public entities that do not file as small business issuers. Therefore, SFAS No. 123(R) will be effective for the Company’s next fiscal year beginning January 1, 2006. This statement eliminates the ability to account for employee stock options using the intrinsic value provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations, and instead generally requires such options to be valued using a fair-value-based method. The Company currently accounts for its stock-based compensation plans for employees in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations. As of the required effective date, public entities will apply SFAS No. 123(R) using a modified version of the prospective transition method. Under that transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS No. 123 for either recognition or pro forma disclosures. The Company is continuing to evaluate the provisions of this statement, the impact on its consolidated financial statements, and the timing and approach to adoption of this statement.
The Company accounts for stock-based compensation for non-employees under the fair value method prescribed by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). On January 12, 2004, the Company’s then CEO, John R. Hamann resigned. As part of the separation agreement between the Company and Mr. Hamann, the expiration date of his 329,683 outstanding options was extended to January 12, 2005. Under generally accepted accounting principles, a modification to terms of an option cancels the existing option, and the option is considered a new issuance. In this case, options issued to a non-employee are accounted for under the fair value method as required under EITF 00-18. The Company recorded $0 and $41,853 for the three months ending September 30, 2005 and 2004, respectively, related to this transaction. The Company recorded $358 and $102,202 for the nine month periods ended September 30, 2005 and 2004, respectively. There were no other stock-based compensation grants to non-employees during 2005 or 2004, respectively.
6
Effective April 8, 2003, the Company entered into two Stock Appreciation Right (SAR) agreements with John R. Hamann and James T. Taylor, granting 170,317 and 99,351 SARs, respectively, at an exercise price of $0.42 per right. The SARs were exercisable immediately upon grant and entitled Messrs. Hamann and Taylor to a cash payment equal to the fair market value, as defined in the agreement, of a share of the Company’s common stock in excess of $0.42 per share. The Company recorded expenses related to SARs of $235,000 and $388,000 for the three and nine month periods ended September 30, 2005 and expenses of $11,000 and $52,000 for the three and nine month periods ended September 30, 2004. Mr. Hamann exercised his SARs in full during 2004, and at September 30, 2005, Mr. Taylor’s 99,351 SARs remain outstanding.
The Company adopted the disclosure provisions of SFAS No. 123. This statement requires the Company to provide pro forma information regarding net income and net income per share as if compensation cost for the Company’s stock options had been determined in accordance with the fair value method. The fair value of these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions for 2005 and 2004.
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| Nine months Ended |
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| 2005 |
| 2004 |
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Dividend yield |
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| 0 | % |
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| 0 | % |
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Expected volatility |
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| 107 | % |
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| 65 | % |
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Risk free interest rate |
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| 4 | % |
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| 3 | % |
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Expected life (years) |
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| 5 |
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| 5 |
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Had compensation cost for the Company’s stock option plans been determined based on the fair value at the grant date consistent with the provisions of SFAS No. 123, the Company’s net income and income per share would have been adjusted to the pro forma amounts indicated below:
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| Three Months Ended |
| Nine months Ended |
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| 2005 |
| 2004 |
| 2005 |
| 2004 |
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| In thousands except per share data |
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Net income as reported |
| $ | 2,663 |
| $ | 263 |
| $ | 5,670 |
| $ | 825 |
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Deduct: Stock-based compensation adjusted for stock option cancellations |
| — |
| — |
| (12 | ) | (2 | ) | ||||
Deduct: Total stock-based compensation expense determined under fair value based method for all awards |
| (17 | ) | (37 | ) | (56 | ) | (64 | ) | ||||
Adjusted net income |
| $ | 2,646 |
| $ | 226 |
| $ | 5,602 |
| $ | 759 |
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Income per share |
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As reported |
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Basic |
| $ | .25 |
| $ | .03 |
| $ | .54 |
| $ | .09 |
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Diluted |
| $ | .25 |
| $ | .02 |
| $ | .53 |
| $ | .08 |
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As adjusted |
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Basic |
| $ | .25 |
| $ | .02 |
| $ | .54 |
| $ | .08 |
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Diluted |
| $ | .25 |
| $ | .02 |
| $ | .53 |
| $ | .07 |
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(d) Warrant Repurchase and Exercises and Option Exercises
On September 27, 2005, the Company repurchased a warrant issued to Comerica Bank-Texas, the Company’s former senior lender, for $1.25 million in cash. The warrant was issued to Comerica Bank on November 26, 2002 in conjunction with an amendment to the Company’s credit agreement and gave Comerica Bank the right to purchase 397,443 shares of common stock at $0.30 per share, expiring November 26, 2007.
7
On February 14, 2005, Mr. Edward P. Evans, a director of the Company, exercised his outstanding warrants in full. The Company received the purchase price of $130,470 and on February 23, 2005 the Company issued 434,899 shares of unregistered common stock to Mr. Evans.
On February 16, 2005, General John T. Chain, Jr., Chairman of the Company, exercised his outstanding warrants in full. The Company received the purchase price of $130,470 and on February 23, 2005, the Company issued 434,899 shares of unregistered common stock to General Chain.
On December 31, 2004, John R. Hamann, former CEO of the Company, exercised stock options for 97,399 shares of common stock. The Company received the purchase price of $36,038 and on January 4, 2005, the Company issued 97,399 shares of registered common stock to Mr. Hamann.
2. Financing Agreements
(a) Senior Credit Facility—On August 16, 2004, the Company agreed to a $5.5 million revolving line of credit with Bank of America, N.A., replacing Comerica bank as the Company’s senior lender. A copy of this loan agreement was filed on August 20, 2004 as Exhibit 99.1 to Form 8-K. All inventory, chattel paper, accounts, equipment and general intangibles of the Company secure the credit facility. The line of credit is subject to a borrowing base calculated as a percentage of the Company’s eligible United States trade accounts receivable less than 90 days old. The credit facility matures August 21, 2006, and bears interest at the prime rate, or LIBOR plus 2.5%, if elected, to be paid monthly. The unused portion of the line of credit bears interest at an annual rate of 0.375%, paid quarterly. The credit agreement contains financial and non-financial covenants, which if breached, could result in acceleration of amounts owed under the credit facility and the senior lender would be able to foreclose on the Company’s assets. The financial covenants were amended on June 8, 2005, in conjunction with an amendment to release a prohibition against the repayment of subordinated debt. The amended covenants are tested quarterly and require the Company to maintain a debt service coverage ratio of at least 1.25 to 1, maintain a funded debt to EBITDA ratio of 2.5 to 1, maintain a minimum rolling 12 month EBITDA of $1.7 million, and restrict annual capital expenditures to $0.5 million or less. The Company utilized the credit line with Bank of America, N.A. to meet working capital requirements during 2005 and 2004. Prior to August 16, 2004, the Company utilized a credit facility with its former senior lender, Comerica Bank. At September 30, 2005, no amounts were outstanding under the line of credit, and the Company was in compliance with all of its debt covenants.
(b) Subordinated Financing—In 2002, the Company issued two promissory notes totaling $1.4 million to its current Chairman of the Board, General John T. Chain, Jr. The notes were subordinated to the Company’s senior lender and matured in 2006, and at December 31, 2004, $1.4 million remained outstanding. On February 7, 2005, the Company signed an amendment to its credit facility with Bank of America, N.A. allowing, but not requiring, the Company to make regularly scheduled principal payments of $0.1 million each month against General Chain’s subordinated debt provided that the Company was not in default on any agreement with Bank of America, N.A. The Company made five payments of $0.1 million each, reducing the subordinated debt balance to $0.9 million. On June 8, 2005, the Company signed an amendment to the credit facility releasing the prohibition against repayment of subordinated debt. On June 9, 2005, the Company repaid the remaining $0.9 million balance, including unpaid interest, of its then outstanding subordinated debt.
8
3. Earnings Per Share—Basic earnings per share is based on the number of weighted average shares outstanding. Diluted earnings per share includes the effect of dilutive securities such as stock options and warrants. The following table reconciles basic earnings per share to diluted earnings per share under the provisions of Statement of Financial Accounting Standards No. 128, “Earnings Per Share.”
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| Three Months Ended |
| Nine months Ended |
| ||||||||
|
| 2005 |
| 2004 |
| 2005 |
| 2004 |
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| In thousands, except per share data |
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Numerator: |
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Net income |
| $ | 2,663 |
| $ | 263 |
| $ | 5,670 |
| $ | 825 |
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Denominator: |
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Weighted Average Shares Outstanding: |
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Basic |
| 10,655 |
| 9,665 |
| 10,465 |
| 9,648 |
| ||||
Effect of dilutive securities: |
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Common stock options and warrants |
| 129 |
| 864 |
| 184 |
| 911 |
| ||||
Diluted |
| 10,784 |
| 10,529 |
| 10,649 |
| 10,559 |
| ||||
Income per share: |
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|
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|
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| ||||
Basic |
| $ | .25 |
| $ | .03 |
| $ | .54 |
| $ | .09 |
|
Diluted |
| $ | .25 |
| $ | .02 |
| $ | .53 |
| $ | .08 |
|
Stock options and warrants outstanding that are not included in the diluted earnings per share computation, due to the anti-dilutive effects, were approximately 501,000 and 507,000 for the three and nine month periods ended September 30, 2005, and approximately 863,000 and 825,000 for the three and nine month periods ended September 30, 2004, respectively. Such options and warrants are excluded due to exercise prices exceeding the average market value of the Company’s common stock.
4. Significant Clients—The Company recorded revenue from one client of $7.3 million and $20.2 million, or 62% and 65% of revenue, for the three and nine month periods ended September 30, 2005, respectively. Revenue from the same client totaled $3.4 million and $10.3 million, or 47% and 46% of revenue, for the three and nine month periods ended September 30, 2004, respectively.
The Company recorded revenue from a second client of $3.9 million and $9.5 million, or 34% and 30% of revenue, for the three and nine month periods ended September 30, 2005, respectively. Revenue from the same client totaled $2.4 million and $7.2 million, or 33% and 32% of revenue, for the three and nine month periods ended September 30, 2004, respectively.
There were no other clients from whom revenue exceeded 10% of total revenue in the three and nine month periods ended September 30, 2005 and 2004, respectively.
5. Concentration of Credit Risk—Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of trade receivables. The Company encounters a certain amount of credit risk as a result of a concentration of receivables among a few significant customers. Accounts receivable from the Company’s largest customer, CACI, INC.—FEDERAL (formerly known as CACI AB, Inc. and previously Action Burnell, Inc.), a wholly-owned subsidiary of CACI International Inc. (www.caci.com), totaled $5.0 million and $3.2 million, or 66% and 61%, of accounts receivable at September 30, 2005 and December 31, 2004, respectively. Accounts receivable from another client, the United States Navy, totaled $2.4 million and $1.2 million, or 32% and 23%, of accounts receivable at September 30, 2005 and December 31, 2004, respectively.
6. Comprehensive Income or Loss—Comprehensive income or loss includes all changes in equity (foreign currency translation), except those resulting from investments by owners and distributions to
9
owners. For the three and nine month periods ended September 30, 2005 and 2004, net income is the only component of comprehensive income.
7. Legal Proceedings—The Company has become subject to various claims and other legal matters, such as collection matters initiated by the Company, in the course of conducting its business. The Company believes that neither such claims and legal matters nor the cost of prosecuting and/or defending such claims and legal matters will have a material adverse effect on the Company’s consolidated results of operations, financial condition or cash flows. No material claims are currently pending; however, no assurances can be given that future claims, if any, may not be material.
8. Supplemental Disclosure of Cash Flow Information
|
| Nine months Ended |
| ||||
|
| 2005 |
| 2004 |
| ||
|
| In thousands of dollars |
| ||||
Interest paid |
| $ | 138 |
| $ | 239 |
|
Taxes paid |
| $ | 99 |
| $ | 159 |
|
9. Segment Data—The Company operates in one industry segment, but conducts its business primarily in three geographic areas: North America, Europe and Asia/Pacific. Information regarding these areas follows:
|
| Three Months Ended |
| Nine months Ended |
| ||||||||
|
| 2005 |
| 2004 |
| 2005 |
| 2004 |
| ||||
|
| In thousands of dollars |
| ||||||||||
Revenue: |
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| ||||
North America |
| $ | 11,786 |
| $ | 7,084 |
| $ | 31,333 |
| $ | 21,088 |
|
Europe |
| — |
| — |
| — |
| 10 |
| ||||
Asia/Pacific |
| — |
| 202 |
| 29 |
| 1,056 |
| ||||
Total revenue |
| $ | 11,786 |
| $ | 7,286 |
| $ | 31,362 |
| $ | 22,154 |
|
Gross profit(loss): |
|
|
|
|
|
|
|
|
| ||||
North America |
| $ | 6,553 |
| $ | 3,775 |
| $ | 17,048 |
| $ | 11,329 |
|
Europe |
| — |
| — |
| — |
| 11 |
| ||||
Asia/Pacific |
| — |
| (182 | ) | 1 |
| (607 | ) | ||||
Total gross profit |
| $ | 6,553 |
| $ | 3,593 |
| $ | 17,049 |
| $ | 10,733 |
|
|
| September 30, |
| December 31, |
| ||||||
|
| In thousands of dollars |
| ||||||||
Long-lived assets: |
|
|
|
|
|
|
|
|
| ||
North America |
|
| $ | 574 |
|
|
| $ | 728 |
|
|
Europe |
|
| — |
|
|
| 19 |
|
| ||
Asia/Pacific |
|
| 1 |
|
|
| 7 |
|
| ||
Corporate |
|
| 61 |
|
|
| 76 |
|
| ||
|
|
| $636 |
|
|
| $ | 830 |
|
| |
10. Income Taxes—At December 31, 2004, the Company had approximately $9.2 million of state net operating loss (NOL) carryforwards, which expire at various times. The Company also had approximately $3.2 million in foreign NOL carryforwards at December 31, 2004 of which $0.7 million were in Asian subsidiaries and $2.5 million were in European subsidiaries. Due to liquidation proceedings and operating losses in these subsidiaries, the foreign NOLs will likely be forfeited, and therefore no deferred tax asset
10
has been established for the foreign NOLs. At December 31, 2004 the Company had $11.4 million of United States Federal NOL carryforwards, of which $3.3 million is subject to a $0.2 million annual limitation under Section 382 of the Internal Revenue Code of 1986, as amended, and expires in 2022. The remaining $8.1 million NOL carryforward was generated in 2004 and is not currently subject to the Section 382 annual limitation and expires in 2024. Due to these NOL carryforwards, the Company estimates its effective tax rate for 2005 to be approximately 3%. For the three and nine month periods ended September 30, 2005, the Company recorded income tax expense of $89,000 and $190,000, respectively. The Company recorded income tax expense of $15,000 and $16,000 for the three and nine month periods ended September 30, 2004, respectively.
Currently, the Company records no net deferred tax assets because the Company believes the recovery of its net deferred tax assets is uncertain. The Company’s net deferred tax assets have been offset by a valuation allowance. While a valuation allowance is currently required for the Company’s net deferred tax assets, the United States deferred tax assets remain available for use in the future to offset future income tax liabilities, should sufficient amounts of United States and foreign income be generated in the carryforward periods. Utilization of net operating loss carryforwards generated in 2004 may be limited in the future if changes in the Company’s stock ownership create a change in control as provided in Section 382 of the Internal Revenue Code of 1986, as amended.
11. Exit Activities—In the second quarter of 2005, management of the Company committed to an exit plan related to its wholly owned subsidiary in Switzerland. This action was taken in response to declining revenue and cash flows from the operations of this subsidiary during 2004 and 2005. All existing revenue contracts of this subsidiary were completed in the second quarter of 2004, and the subsidiary had no significant assets or operations. Selling efforts during 2004 and the first quarter of 2005 were unsuccessful, and as a result, management decided to liquidate the Swiss subsidiary. The exit plan will result in the incurrence of costs having no future economic benefit; however, the costs are not material and the activities to be discontinued in Switzerland are not significant to the Company’s revenue or operating results. Approximately $178,000 was accrued for costs expected to be incurred during the last half of 2005 and was classified as a current liability at June 30, 2005, based on the expected completion date of the liquidation, and included in selling, general and administrative expenses for the second quarter of 2005. The accrual is comprised of $108,000 in compensation and benefits, $9,000 in losses on disposal of assets, $34,000 in legal and accounting costs and $27,000 in other administrative costs. For the three months ended September 30, 2005, approximately $90,000 in cash was paid related to exit activities and at September 30, 2005 there was approximately $81,000 in accrued compensation, legal, and other administrative costs remaining classified as a current liability based on the expected completion date of the liquidation.
12. Accumulated Other Comprehensive Loss—At September 30, 2005 the accumulation of prior years’ foreign currency translation adjustments of approximately $682,000 included in accumulated other comprehensive loss relates primarily to the Company’s operations in Switzerland. The Company is in the process of liquidating its subsidiaries in Switzerland, and as a result, will reclassify the appropriate amount to the income statement upon substantial completion of the liquidation. The Company believes the transaction will be complete during 2006 and the resulting reclassification will be recorded as a non-cash charge to operations for the year then ended.
11
ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company derives the majority of its revenue from monthly fixed and incentive fees for the implementation of its Process Value Management (“PVM”) approach. Incentive fees are tied to improvements in a variety of client performance measures typically involving response time, asset utilization and productivity. Due to the Company’s use of incentive fee contracts, variations in revenue levels may cause fluctuations in quarterly results. Factors such as a client’s commitment to a PVM program, general economic and industry conditions, and other issues could affect a client’s business performance, thereby affecting the Company’s incentive fee revenue and quarterly earnings. Quarterly revenue and earnings of the Company may also be impacted by the size and timing of starts and completions of individual contracts.
The majority of transactions in all regions in which the Company operates are denominated using the United States dollar. However, some of the Company’s transactions are in foreign currencies; therefore, the Company is exposed to currency fluctuation risk. See Item 3 “Quantitative and Qualitative Disclosure About Market Risk”.
General—The presentation of financial statements in conformity with accounting principles generally accepted in the United States 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. The Company reviews all significant estimates affecting the financial statements on a recurring basis and records the effect of any necessary adjustments prior to their issuance. Critical accounting policies are those policies that the Company believes present the most complex or subjective measurements and have the most potential to impact our financial position and operating results. While all decisions regarding accounting policies are important, the Company believes that there are three accounting policies that could be considered critical. These critical accounting policies include revenue recognition, unbilled services, and deferred tax asset valuation allowance.
Revenue Recognition—Contracts specify fixed fees, task-based or deliverable based fees, or incentives based on improvements achieved. Revenue is recognized when realizable and earned generally as services are provided over the life of the contract. Fixed fee revenue is recognized on a percentage completion method, based on direct labor hours expended. Task-based, or deliverable based, fees are recognized when the task or deliverable is completed. Incentive fee revenue is recognized in the period in which the related improvements are achieved. In order to mitigate the risk of disputes arising over the achievement of performance improvements, which drive incentive fees, the Company obtains customer agreement to these achievements prior to recognizing revenue.
Unbilled Receivables—Although fixed fee revenue recognition generally coincides with billings, as an accommodation to its clients, the Company may structure fee billings to increase in the latter stages of a program. In such instances, revenues recognized for services provided are represented in unbilled receivables.
Deferred Tax Asset Valuation Allowance—The Company assesses all available evidence to make a judgment concerning the realizability of its deferred tax asset. Such evidence consists of tax planning strategies, negative evidence (recent history of operating losses or tax credit carryforwards expiring unused, restrictions on net operating loss carryforwards under Section 382 of the Internal Revenue Code of 1986, as amended), and positive evidence (existing contracts, firm sales backlog, strong earnings history). After
12
evaluation of all available evidence, the Company adjusts its valuation allowance accordingly. The Company considers its valuation allowance to be a significant estimate. The Company has provided a full valuation allowance against its deferred tax asset due to the preponderance of negative evidence indicating that these deferred taxes will not be recoverable.
The foregoing list is not intended to be a comprehensive list of all the Company’s accounting policies. For a more detailed description of the Company’s significant accounting policies and basis of presentation, see the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004.
The following table sets forth the percentages which items in the statement of operations bear to revenue:
|
| Three Months Ended |
| Nine Months Ended |
| ||||
|
| 2005 |
| 2004 |
| 2005 |
| 2004 |
|
Revenue |
| 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |
Cost of sales |
| 44.4 | % | 50.7 | % | 45.6 | % | 51.6 | % |
Gross profit |
| 55.6 | % | 49.3 | % | 54.4 | % | 48.4 | % |
Selling, general and administrative |
| 32.4 | % | 44.6 | % | 35.4 | % | 43.5 | % |
Sublease losses |
| — |
| — |
| 0.2 | % | — |
|
Operating income |
| 23.2 | % | 4.7 | % | 18.8 | % | 4.9 | % |
Other income/(expense) |
| .1 | % | (0.9 | )% | (0.1 | )% | (1.1 | )% |
Income before income taxes |
| 23.3 | % | 3.8 | % | 18.7 | % | 3.8 | % |
Income taxes |
| 0.7 | % | 0.2 | % | 0.6 | % | 0.1 | % |
Net income |
| 22.6 | % | 3.6 | % | 18.1 | % | 3.7 | % |
Three Month Period Ended September 30, 2005 Compared to the Three Month Period Ended September 30, 2004
Revenue—In the third quarter of 2005, revenue increased $4.5 million, or 62%, to $11.8 million from $7.3 million in the third quarter of 2004.
Fixed fee revenue was $11.8 million, or 100% of revenue in the third quarter of 2005, compared to $7.2 million, or 99% of revenue in the third quarter of 2004. Incentive revenue was $0, or 0%, of revenue in the third quarter of 2005, compared to $0.1 million, or 1%, of revenue in the third quarter of 2004. Reimbursements were $23,000, or 0.2%, of revenue in the third quarter of 2005, compared to $9,000, or 0.1%, of revenue in the third quarter of 2004.
North America region revenue increased $4.7 million, or 66%, to $11.8 million in the third quarter of 2005 compared to $7.1 million in the third quarter of 2004. Revenue from commercial clients decreased $0.1 million, or 17%, to $0.5 million in the third quarter of 2005 compared to $0.6 million in the third quarter of 2004. Revenue from United States government contracts increased $4.9 million, or 77%, to $11.3 million in the third quarter of 2005 compared to $6.4 million in the third quarter of 2004.
Asia/Pacific region revenue decreased $182,000, or 100%, to $0 in the third quarter of 2005 compared to the third quarter of 2004. The Company maintains limited sales and marketing activities in the region at a minimal cost to the Company.
The Company recorded no revenue in the Europe region during the third quarter of 2005 or 2004. The Company maintains only limited administrative staff in Europe and is in the process of liquidating its remaining European subsidiaries.
13
Gross Profit—Gross profit margins were 56% of revenue, or $5.2 million, in the third quarter of 2005, compared to 49%, or $3.6 million, in the third quarter of 2004. The increase in gross profit margin is primarily attributable to acquiring contract expansions that did not require a ratable increase in resources.
Selling, General and Administrative Expenses—Selling, general and administrative expenses increased $0.5 million to $3.8 million in the third quarter of 2005 compared to $3.3 million in the third quarter of 2004. The increase is primarily related to $0.7 million in performance compensation and a $0.1 million reserve for bad debt, offset by a $0.3 million reduction in selling costs and other costs related to service providers.
Nine Month Period Ended September 30, 2005 Compared to the Nine Month Period Ended September 30, 2004
Revenue—Revenue increased $9.2 million, or 41%, to $31.3 million in the first nine months of 2005 compared to $22.2 million in the first nine months of 2004.
Fixed fee revenue increased $9.5 million, or 44%, to $31.2 million, or 99%, of revenue in the first nine months of 2005 compared to $21.7 million, or 98%, of revenue in the first nine months of 2004. Incentive revenue decreased $0.3 million to $0.1 million, or 1%, of revenue in the first nine months of 2005 compared to $0.4 million, or 1%, of revenue in the first nine months of 2004. Reimbursements were $29,000, or 0%, of revenue in the first nine months of 2005 compared to $91,000, or 0%, of revenue in the first nine months of 2004.
North America region revenue increased $10.2 million, or 48%, to $31.3 million in the first nine months of 2005 compared to $21.1 million in the first nine months 2004. Revenue from commercial clients decreased $0.6 million, or 35%, to $1.1 million in the first nine months of 2005 compared to $1.7 million in the first nine months of 2004. Revenue from United States government contracts increased $10.8 million, or 56%, to $30.2 million in the first nine moths of 2005 compared to $19.3 million in the first nine months 2004.
Asia/Pacific region revenue decreased $1.0 million, or 99%, to $29,000 in the first nine months of 2005 compared to $1.0 million in the first nine months 2004. The Company maintains limited sales and marketing activities in the region at a minimal cost to the Company.
The Company recorded no revenue in the Europe region during the first nine months of 2005 compared to $9,000 for the first nine months of 2004. The Company maintains only limited administrative staff in Europe and is the process of liquidating its remaining European subsidiaries.
Gross Profit—Gross profit margins were 54% of revenue, or $17.0 million, in the first nine months of 2005 compared to 48%, or $10.7 million, in the first nine months of 2004. The increase is primarily attributable to increased revenue while maintaining full utilization of the Company’s direct labor, and strict control over travel, telecommunications, and other costs directly related to service delivery.
Selling, General and Administrative Expenses—Selling, general and administrative expenses increased $0.9 million to $10.5 million in the first nine months of 2005 compared to $9.6 million in the first nine months of 2004. This increase is primarily exit costs recorded in the second quarter of 2005 and performance compensation earned by employees, which was recorded in the third quarter of 2005.
Sublease Losses—The Company subleases unneeded office space in Detroit, MI and Reston, VA. During the first quarter of 2005, subtenants of both offices ceased paying rent. Agreements were reached with new subtenants at market rates for both spaces. The Company recorded a $0.6 million expense and a related liability in the first quarter of 2005 by estimating the future cash flows to be used in settling the leases, net of estimated sublease income to be received under the new agreements. The liability balance is reduced monthly by the net of cash received from subtenants and cash disbursed to the Company’s
14
landlords. The remaining balance at September 30, 2005 was $0.3 million of which, based on the expected time of payment, $0.1 million was classified as a current liability and $0.2 million was classified as a long-term liability.
Liquidity and Capital Resources
Cash and cash equivalents increased by $2.4 million during the first nine months of 2005 compared to a $1.9 million decrease during the first nine months of 2004. The major components of these changes are discussed below:
Cash Flows from Operating Activities—Operating activities provided net cash of $5.2 million in the first nine months of 2005, compared to net cash provided by operating activities of $50,000 in the first nine months of 2004. The increase in net cash provided is primarily due to 2005 profits in excess of 2004 profits.
Cash Flows from Investing Activities—Cash used in investing activities consisted primarily of upgrades to computer equipment and totaled $75,000 in the first nine months of 2005, compared to $24,000 in the first nine months of 2004.
Cash Flows from Financing Activities—Cash flows used in financing activities were approximately $2.8 million, comprised of $1.8 million used to repay debt, $1.3 million used to repurchase warrants, offset by $0.3 million generated from the issuance of common stock upon the exercise of outstanding options and warrants. Cash used for financing activities in the first nine months of 2004 was $2.0 million, primarily for debt repayments.
The Company currently has a stock repurchase plan, which allows the Company to repurchase up to 750,000 shares of the Company’s common stock. The Company has approximately 505,450 shares available to purchase under this plan. The Company has purchased no treasury shares since October of 2001.
The Company has no material commitments for capital expenditures or off-balance sheet arrangements as of the end of the last fiscal period.
Liquidity Plan—As a result of net cash provided by operations, the Company reduced its senior debt $4.5 million in 2003 and $2.4 million in 2004. During the first nine months of 2005, the Company repaid its $1.4 million subordinated debt in full and used its line of credit to fund operations as needed. The Company’s ability to reduce debt and generate cash from operations is due primarily to revenue increases, cost saving measures such as downsizing and subleasing facilities, and more aggressive collection policies. The Company’s ability to maintain gross margins, control costs and generate cash flow from operations in the future will determine its ability to make payments on debts as they become due and to remain in future compliance with debt covenants. The Company regularly evaluates its business to enhance its liquidity position.
The Company’s performance will also be affected by prevailing economic conditions. Many of these factors are beyond the Company’s control. Recent conflicts throughout the world involving the United States military could potentially have an adverse affect on the Company’s liquidity due to the high concentration of United States government contracts, which could result in delays in program operations. If future cash flows and capital resources are insufficient to meet the Company’s debt obligations and commitments, the Company may be forced to reduce or delay activities and capital expenditures, obtain additional equity capital or restructure or refinance its debt.
The Company believes that the bank debt facility described in Note 2 above provides adequate liquidity based on the Company’s current growth strategies and cost control measures. The Company also believes that cash flows provided by operating activities will be sufficient to service debt payments as they become due. In the event that revenue growth exceeds anticipated levels, the Company may be required to seek additional financing.
15
Although the operations of the Company are influenced by general economic conditions, the Company does not believe inflation had a material effect on the results of operations during the three and nine month periods ended September 30, 2005 or 2004. However, there can be no assurance the Company’s business will not be affected by inflation in the future.
“Safe Harbor” Statement Under The Private Securities Litigation Reform Act:
Certain information contained in this report constitutes “forward-looking statements.” Forward-looking statements are those that use the words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “may,” “will,” “likely,” “should,” “estimate,” “continue,” “future” or the negative thereof, other variations thereon or other comparable expressions. These words indicate future events and trends. Forward-looking statements are the Company’s current views with respect to future events and financial performance. These forward-looking statements are subject to many assumptions, risks and uncertainties that could cause actual results to differ significantly from historical results or from those anticipated by the Company. It is advisable not to place undue reliance on the Company’s forward-looking statements. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. The most significant risks are detailed from time to time in the Company’s filings and reports with the Securities and Exchange Commission including this Quarterly Report on Form 10-Q and the following:
· The competitive nature of the management consulting industry, in light of new entrants into the industry and the difficulty of differentiating the services offered to potential clients;
· The time required by prospective clients to fully understand the value and complexity of a typical PVM program may result in an extended lead time to close new business;
· Performance-oriented fees are earned upon the achievement of improvements in a client’s business. The client’s commitment to a PVM program and general economic/industry conditions could impact a client’s business performance and consequently the Company’s ability to forecast the timing and ultimate realization of performance-oriented fees;
· The ability of the Company to productively re-deploy personnel during program transition periods; and
· The ability of the Company to create alliances and make acquisitions that are accretive to earnings.
ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Company invests cash balances in excess of operating requirements in short-term securities, generally with maturities of 90 days or less. The Company’s credit agreement provides for borrowings, which bear interest at the prime rate, or LIBOR plus 2.5%, if elected. Since January 1, 1995, the prime rate has fluctuated between 9.5% and 4.0% and the 1-year LIBOR rate has fluctuated between 7.75% and 1.2%. Based on the volatility of the prime rate in recent years, a five-percentage point increase in interest rates would have resulted in $26,000 of additional interest expense in 2005. Through November 11, 2005, the Company had $5.2 million in borrowings and $5.6 million in repayments on its revolving line of credit, and on November 11, 2005 no borrowings were outstanding.
Due to the Company’s foreign operations in Europe and Asia, the Company is exposed to transaction adjustments with respect to foreign currency. The Company’s functional currency is the United States dollar. Under United States dollar functional currency, the financial statements of foreign subsidiaries are remeasured from the recording currency to the United States dollar. The resulting remeasurement adjustment is recorded as foreign exchange gain or loss in the statement of operations. There is no
16
translation adjustment to the separate component of stockholders’ equity or adjustment to comprehensive income. The Company incurred foreign exchange gains of $3,000 for the nine months ended September 30, 2005 and foreign exchanges losses of $5,000 for the nine months ended September 30, 2004. At September 30, 2005, the effect of a 10% increase in foreign exchange rates would have resulted in a $6,000 foreign currency exchange loss on the Company’s non-United States denominated assets and a $8,000 foreign exchange gain on the Company’s non-United States denominated liabilities. As such, the net effect of a 10% increase in the Company’s foreign exchange rates, at September 30, 2005, would have been a $2,000 foreign currency exchange gain. The Company believes that operating under United States dollar functional currency, combined with transacting business in countries with traditionally stable currencies mitigates the effect of any near-term foreign currency transaction adjustments on the Company’s financial position, results of operations and cash flows.
The Company has not engaged in foreign currency hedging transactions nor does the Company have any derivative financial instruments. However, going forward, the Company will assess the need to enter into hedging transactions to limit its risk due to fluctuations in exchange rates.
ITEM 4—CONTROLS AND PROCEDURES
Based on the evaluation of the Company’s disclosure controls and procedures as of the end of the period covered by this quarterly report, James T. Taylor, the President, Chief Executive Officer and Secretary, and David English, Vice President, Chief Financial Officer, Assistant Secretary and Treasurer, have concluded that, in their judgment, the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company, including the Company’s subsidiaries, in the reports it files, or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures, which, by their nature, can provide only reasonable assurance regarding management’s control objectives. The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.
There were no changes in the Company’s internal controls over financial reporting during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.
17
Exhibits |
|
|
10.1 |
| Employment Agreement between the Company and David English, dated November 7, 2005. |
|
|
|
31.1 |
| Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. |
|
|
|
31.2 |
| Certification of Chief Financial Officer pursuant to Rule 13a-14 (a) under the Securities Exchange Act of 1934. |
|
|
|
32.1 |
| Certification of Chief Executive Officer 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 Chief Financial Officer pursuant to 18 U.S.C., Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
18
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.
| THOMAS GROUP, INC. | |||
|
| Registrant | ||
November 10, 2005 |
|
|
| /s/ JAMES T. TAYLOR |
Date |
| James T. Taylor | ||
|
| President and Chief Executive Officer | ||
|
| /s/ DAVID ENGLISH | ||
|
| David English | ||
|
| Vice-President and Chief Financial Officer | ||
19