U.S.SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-QSB (Mark One) [X] Quarterly Report under Section 13 or 15(d) of the Securities Exchange Act of 1934 	 For the quarterly period ended: May 31, 1998 [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ____________ to ____________ Commission File Number 0-18250 TMS, Inc. (Exact name of small business issuer as specified in its charter) 	 OKLAHOMA 91-1098155 (State or other jurisdiction of (I.R.S. Employer Identification Number) incorporation or organization) 206 West Sixth Street Post Office Box 1358 Stillwater, Oklahoma 74075 (Address of principal executive offices) Issuer's telephone number, including area code: (405) 377-0880 Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: Title of Each Class Outstanding at May 31, 1998 Common stock, par value $.05 per share 13,303,966 Transitional Small Business Disclosure Format(check one): Yes [ ] No [X] 1 PART I - FINANCIAL INFORMATION Item 1. Financial Statements TMS, Inc. Condensed Balance Sheets May 31, 1998 and August 31, 1997 May 31, August 31, 1998 1997 ---- ---- Cash $ 523,499 426,174 Trade accounts receivable, net 1,144,686 1,235,195 Contract service work in process 828,002 579,137 Other current assets 240,546 322,291 ------------ ----------- Total current assets 2,736,733 2,562,797 ------------ ----------- Property and equipment 3,143,560 2,714,181 Accumulated depreciation and amortization (1,439,256) (1,167,738) ------------ ----------- Net property and equipment 1,704,304 1,546,443 ------------ ----------- Capitalized software development costs, net 559,390 499,444 Other assets 238,758 238,342 ------------ ----------- Total assets 5,239,185 4,847,026 ============ =========== Note payable 0 78,000 Accounts payable 185,112 247,123 Other current liabilities 510,377 442,765 ------------ ----------- Total current liabilities 695,489 767,888 Obligation under capital lease, net of current installments 94,357 0 Long-term debt, net of current installments 315,994 333,618 ------------ ----------- Total liabilities 1,105,840 1,101,506 ------------ ----------- Common stock 672,555 671,552 Additional paid-in capital 11,475,065 11,473,561 Unamortized deferred compensation (25,039) (30,048) Accumulated deficit (7,910,351) (8,290,660) Treasury stock (78,885) (78,885) ------------ ----------- Total shareholders' equity 4,133,345 3,745,520 ------------ ----------- Total liabilities and shareholders'equity $ 5,239,185 4,847,026 ============ =========== See accompanying notes to condensed financial statements. 2 TMS, Inc. Condensed Statements of Operations Three and Nine Months Ended May 31, 1998 and 1997 Three Months Ended Nine Months Ended 1998 1997 1998 1997 ---- ---- ---- ---- Revenue: Licensing and royalties $ 1,036,067 1,041,376 3,459,939 2,609,058 Software development services 260,155 164,373 999,412 1,010,639 Document conversion services 420,413 244,123 1,308,589 503,121 ------------ ---------- ---------- ---------- 1,716,635 1,449,872 5,767,940 4,122,818 ------------ ---------- ---------- ---------- Operating costs and expenses: Cost of licensing and royalties 245,901 255,954 685,819 768,390 Cost of software development services 194,355 193,864 649,098 618,878 Cost of document conversion services 303,878 122,823 944,917 314,464 Selling, general and administrative 935,963 854,325 2,991,371 2,407,017 ------------ ---------- ---------- ---------- 1,680,097 1,426,966 5,271,205 4,108,749 ------------ ---------- ---------- ---------- Operating income 36,538 22,906 496,735 14,069 Other (expense) income, net (6,648) 9,966 (27,165) 32,006 ------------ ---------- ---------- ---------- Income before income taxes 29,890 32,872 469,570 46,075 Income tax expense 5,679 17,300 89,261 18,100 ------------ ---------- ---------- ---------- Net income $ 24,211 15,572 380,309 27,975 ============ ========== ========== ========== Basic earnings per share $ 0.00 $ 0.00 $ 0.03 $ 0.00 ============ ========== ========== ========== Weighted average common shares 13,303,156 13,427,049 13,294,693 13,331,492 ============ ========== ========== ========== Diluted earnings per share $ 0.00 $ 0.00 $ 0.03 $ 0.00 ============ ========== ========== ========== Weighted average common and common equivalent shares 13,619,269 14,053,463 13,751,598 14,100,888 ============ ========== ========== ========== See accompanying notes to condensed financial statements. 3 TMS, Inc. Condensed Statements of Cash Flows Nine Months Ended May 31, 1998 and 1997 1998 1997 ---- ---- Net cash flows provided by operating activities $ 827,836 285,991 ---------- --------- Cash flows from investing activities: Purchases of property and equipment (247,055) (229,375) Capitalized software development costs (355,088) (235,240) Patent costs (2,181) (6,223) Proceeds from sale of equipment 0 7,245 ---------- --------- Net cash used in investing activities (604,324) (463,593) ---------- --------- Cash flows from financing activities: Repayment of long-term debt (18,300) (15,541) Repayment of capital lease obligation (32,394) 0 Proceeds from short-term note payable 340,000 0 Repayments of short-term note payable (418,000) 0 Issuance of common stock 2,507 67,741 ---------- --------- Net cash (used in) provided by financing activities (126,187) 52,200 ---------- --------- Net increase (decrease) in cash 97,325 (125,402) Cash at beginning of period 426,174 546,745 ---------- --------- Cash at end of period $ 523,499 421,343 ========== ========= See accompanying notes to condensed financial statements. 4 TMS, Inc. Notes to Condensed Financial Statements Basis for Presentation - ---------------------- The information included in the Condensed Financial Statements is unaudited, but includes all adjustments which are, in the opinion of management, necessary for a fair presentation of the interim periods presented. These Condensed Financial Statements should be read in conjunction with the Company's 1997 Annual Report filed on Form 10-KSB. Earnings Per Share - ------------------ Statement of Financial Accounting Standards No. 128 (SFAS No. 128), "Earnings per Share", supersedes APB Opinion 15 (APB No. 15), "Earnings per Share", and is effective for interim and annual periods ending after December 15, 1997. SFAS No. 128 replaces primary EPS with basic EPS and fully diluted EPS with diluted EPS. Basic EPS is computed by dividing net income by the weighted- average number of shares of common stock outstanding during the period. Diluted EPS recognizes the potential dilutive effects of the future exercise of common stock options utilizing the same computations that the Company currently uses to compute primary EPS under APB No. 15. The Condensed Statements of Operations reflect the adoption of SFAS No. 128 for all interim periods presented. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 	 This Quarterly Report on Form 10-QSB contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results could differ materially from those set forth in the forward-looking statements because of certain risks and uncertainties, such as those inherent generally in the computer software industries and the impact of competition, pricing, and changing market conditions. As a result, the reader is cautioned not to place reliance on these forward-looking statements. RESULTS OF OPERATIONS The following discussion should be read in conjunction with the attached condensed financial statements and notes thereto and with the Company's audited financial statements and notes thereto for the fiscal year ended August 31, 1997. QUARTER ENDED MAY 31, 1998 COMPARED TO MAY 31, 1997 REVENUE - Total revenue for the third quarter of fiscal 1998 was $1,716,635 compared to $1,449,872 for the same quarter of fiscal 1997, an increase of $266,763 or 19%. Licensing and royalties revenue for the third quarter of fiscal 1998 was flat as compared to the same quarter of fiscal 1997. Third quarter revenue from imaging products decreased 4% to $618,895 compared to the $639,143 reported for the third quarter last year. The decrease in imaging revenue primarily resulted from a decline in ViewDirector royalties reported during the current quarter. Third quarter revenue from image enhancement products (e.g. ScanFix, FormFix) increased $7,223, or 3%, over the same quarter last year. Software development service revenue for the third quarter of fiscal 1998 was $260,155 compared to $164,373 for the third quarter of fiscal 1997, an increase of $95,782 or 59%. The increase in software development service revenue resulted from continued fulfillment of a significant service contract that was secured in the fourth quarter of fiscal 1997. Revenue from that significant contract represented $217,359, or 84%, of fiscal 1998 third quarter software development services revenue. 5 Document conversion service revenue for the third quarter of fiscal 1998 was $420,413 compared to $244,123 for the third quarter of fiscal 1997, an increase of $176,290 or 73%. Approximately 47%, or $197,951, of the third quarter document conversion service revenue came from one customer. This customer contract was substantially completed during the current quarter. The company expects that revenue from document conversion will significantly decline during the fourth quarter of the current year. The expected decline is a direct result of the Company's recent decision to discontinue pursuit of backfile document conversion projects. During the current year third quarter, revenue from backfile related conversion projects represented approximately 55%, or $232,000, of total document conversion revenue. See the discussion of document conversion under the "OPERATING COSTS AND EXPENSES" section below for additional information related to backfile conversion. OPERATING COSTS AND EXPENSES - Total operating costs and expenses for the quarter ended May 31, 1998 were $1,680,097 compared to $1,426,966 for the same quarter in fiscal 1997, an increase of $253,131 or 18%. The cost of licensing and royalties decreased $10,053, or 4%, for the third quarter of fiscal 1998, compared to the same period a year ago. The gross profit margin for licensing and royalties was 77% and 76% for the three months ended May 31, 1998 and 1997, respectively. The cost of software development services for the third quarter of fiscal 1998 was flat, compared to the same period a year ago. The gross profit margin for software development services was 26% and a negative 18% for the three months ended May 31, 1998 and 1997, respectively. The 59% increase in software development services revenue had the most significant impact on improved gross margins over the same quarter last year. During the current year third quarter, the Company continued to carry technical resource capacity at a higher level than was necessary to fulfill contract requirements. In an effort to increase the opportunities to secure additional service contracts and better match technical capacity, the Company recently hired two experienced salespersons. The Company is in the process of negotiating additional software development opportunities and has secured new contracts for the fourth quarter. Accordingly, the Company believes that gross margins will continue to improve in the fourth quarter, but can give no assurances that this will be the case. The cost of document conversion services increased $181,055, or 148%, for the third quarter of fiscal 1998, compared to the same period a year ago. The gross profit margin for document conversion services was 28% and 50% for the three months ended May 31, 1998 and 1997, respectively. The increase in cost represents the hiring of additional personnel to meet service contract requirements. The decrease in gross profit margins resulted from a combination of several factors. In the prior year third quarter, and historically for document conversion, services have focused on electronic publishing of documents for several large corporations. Within the last nine months, the majority of document conversion services have come from contracts associated with backfile conversion of documents for imaging and database management. The technical complexity associated with backfile conversion is much lower than that of electronic publishing; accordingly, the Company faces more competition in securing backfile conversion contracts which effects pricing downward. In addition to external competition and pricing pressures, the document conversion group has faced internal productivity challenges that have negatively impacted gross margins for the third quarter. Rapid growth has hindered productivity because of the number of new employees and contract workers that were hired to meet service requirements. The contract that accounted for 47% of document conversion revenue in the third quarter (see the discussion of revenue above) is being performed at a customer site, which has increased costs, and has required many more labor resources than was originally expected. This contract was substantially completed in the third quarter. As mentioned in the 6 discussion of document conversion revenue above, the Company made a decision in the third quarter to discontinue pursuit of backfile conversion contracts. Accordingly, the Company expects to see a significant decline in document conversion costs during the fourth quarter due to a reduction in the direct labor force that was required to fulfill backfile contract obligations. The Company continues to fulfill contract obligations associated with electronic publishing of documents. The electronic publishing conversion work is in line with the Company's core competencies and has historically resulted in much higher margins, but lower revenue as compared to backfile related projects. The Company is the in the process of analyzing the need for certain non direct labor personnel, facilities and equipment for the ongoing electronic publishing operations of document conversion. It is possible that in the fourth quarter the Company may record a one-time restructuring charge for employee severance, equipment and other transition costs, but can not reasonably estimate such costs, if any, at the present time. Selling, general and administrative expenses for the third quarter of fiscal 1998 increased $81,638, or 9%, when compared to the third quarter of fiscal 1997. The increase is primarily related to additional personnel costs in the form of merit and cost of living increases and additional resources to support the overall growth of the Company. Income Taxes - ------------ Deferred tax expense of $11,579 for the quarter ended May 31, 1998, was offset by deferred tax benefit of approximately $5,900 attributable to the decrease in the valuation allowance for deferred tax assets. The Company assesses the realizability of deferred tax assets at least quarterly, and adjusts the valuation allowance to reflect the future benefits that will more likely than not be realized from those deferred tax assets. Net Income/Loss - --------------- Net income for the third quarter of fiscal 1998 was $24,211 compared to 15,572 for the third quarter of fiscal 1997. The Company's net income for the third quarter was essentially flat compared to the same period last year even though revenue increased 18%. This is primarily due to the mix of the Company's third quarter revenue being more heavily weighted to document conversion backfile activities which affects overall company margins downward. NINE-MONTHS ENDED MAY 31, 1998 COMPARED TO MAY 31, 1997 REVENUE - Total revenue for the first nine-months of fiscal 1998 was $5,767,940 compared to $4,122,818 for the same period in fiscal 1997, an increase of $1,645,122 or 40%. Licensing and royalties revenue for the first nine-months of fiscal 1998 increased $850,881, or 33%, over licensing and royalties revenue for the same period in fiscal 1997. Nine-month revenue from imaging products increased 34% to $2,052,442 compared to the $1,534,549 reported for the same nine-month period last year. Approximately 91% of the imaging revenue growth came from sales of the Company's Prizm Plug-in product. Prizm Plug-in revenue represented approximately 42% and 26% of imaging revenue for the first nine months of fiscal 1998 and 1997, respectively. Revenue from image enhancement products increased $216,853, or 28%, for the first nine months of the current year as compared to the same period last year. Approximately 59% of the increase in image enhancement revenue came from the Company's ScanFix product that may be used in conjunction with Caere's Omnipage product. The Company secured a co- marketing agreement with Caere, a leader in OCR technology, early in the current fiscal year. Additional sales focus from two additional sales staff for image enhancement products also contributed to growth for the first nine months of the current year. Software development service revenue for the first nine months of fiscal 1998 was $999,412 compared to $1,010,639 for the same period in fiscal 1997, a decrease of $11,227, or 1%. Revenue from one customer represented $660,982, or 66%, of software development services revenue for the first nine months of fiscal 1998. 7 Document conversion service revenue for the first nine months of fiscal 1998 was $1,308,589 compared to $503,121 for the same period in fiscal 1997, an increase of $805,468 or 160%. The Company secured two large back-file conversion contracts during the first nine months of the current fiscal year. Revenue from those two contracts represented approximately 53%, or $698,632, of document conversion service revenue for the first nine months of the current fiscal year. One of the significant contracts was substantially completed early in the second fiscal quarter, but may require some follow-up work through the remainder of the fiscal year. The second significant contract was substantially completed during the current quarter. The Company recently decided to discontinue pursuit of additional backfile conversion projects. This will have a downward impact on both revenue and expenses in the fourth quarter. See the discussion of document conversion revenue and costs in the analysis of the third quarter above for a more detailed discussion of backfile conversion. OPERATING COSTS AND EXPENSES - Total operating costs and expenses for the nine months ended May 31, 1998 were $5,271,205 compared to $4,108,749 for the same period in fiscal 1997, an increase of $1,162,456 or 28%. The cost of licensing and royalties decreased $82,571, or 11%, for the first nine months of fiscal 1998, compared to the same period a year ago. Lower costs may be primarily attributed to an approximate $120,000 increase in capitalized development costs for new and significantly enhanced products. The gross profit margin for licensing and royalties was 80% and 71% for the nine months ended May 31, 1998 and 1997, respectively. The increase in gross profit margin is primarily attributable to the $196,424 or 15%, increase in royalty revenue, which results in little or no cost to the Company. Additionally, the sale of multiple licenses of the Company's complete software applications has had a significant impact on improved gross margins, because revenue from multiple licenses does not result in a proportional increase in unit costs. For the first nine months of the current year, revenue from the Company's complete software applications has increased $618,246 or 90%, compared to the same period last year. The Prizm Plug-in product accounts for 77% of the growth in complete software applications. The cost of software development services increased $30,220, or 5%, for the first nine months of fiscal 1998, compared to the same period a year ago. The gross profit margin for software development services was 35% and 39% for the nine months ended May 31, 1998 and 1997, respectively. The excess technical resource capacity caused gross margins to drop for the first nine months of the current fiscal year, as compared to the same period last year. As mentioned in the discussion of software development costs for the current quarter, the Company recently hired two additional experienced sales staff in an effort to improve the ability to better match service opportunities with technical capacity. As the software development services group continues to re-build its revenue backlog, the Company has decided to retain its current capacity of technical resources. The Company is prepared to make the necessary adjustments by the end of the current fiscal year to improve profitability of software development services. The cost of document conversion services increased $630,453, or 200%, for the first nine months of fiscal 1998, compared to the same period a year ago. The gross profit margins for document conversion services were 28% and 37% for the nine months ended May 31, 1998 and 1997, respectively. The increase in cost represents the hiring of additional personnel to meet service contract requirements. The low gross profit margins for the first nine months in the prior year reflect a certain level of labor and overhead cost that were required to be maintained to support future growth. The low margins for the first nine months of the current year primarily result from a significant increase in the amount of backfile conversion jobs, lower productivity resulting from a significant number of new employees, and a miss-match in the amount of revenue and labor resources for a significant contract. For a more detail explanation of operational issues within document conversion, refer to the "OPERATING COSTS AND EXPENSES" section in the discussion of the fiscal 1998 third quarter above. 8 Selling, general and administrative expenses for the first nine months of fiscal 1998 increased $584,354 or 24%, when compared to the same period in fiscal 1997. The increase in costs is almost entirely due to personnel related expenses. As mentioned in the company's 10-KSB for the fiscal year ending August 31, 1997, the company made several market adjustments to salaries in addition to regular merit and cost of living increases. The company also improved employee benefit offerings by implementing a 401(k)-retirement plan matching program and absorbing 25% more of the cost of employee medical insurance premiums. The majority of these changes occurred at the beginning of the fiscal 1997 third quarter. During the first quarter of fiscal 1998, the Company also adopted an incentive compensation plan that provides cash rewards to all employees if certain revenue and profit goals are achieved. The Company recognized approximately $63,000 of incentive expense for the first nine months of the fiscal year. Income Taxes - ------------ Deferred tax expense of $178,437 for the nine months ended May 31, 1998, was offset by a deferred tax benefit of approximately $89,176 attributable to the decrease in the valuation allowance for deferred tax assets. The Company assesses the realizability of deferred tax assets at least quarterly, and adjusts the valuation allowance to reflect the future benefits that will more likely than not be realized from those deferred tax assets. Net Income - ---------- Net income for the first nine months of fiscal 1998 was $380,309 or $.03 per share, compared to $27,975, or $.00 per share, for the first nine months of fiscal 1997. Revenue growth and increased gross profit margins for licensing and royalties were the primary factors that contributed to improved net income over the prior year. Impact of Year 2000 Issue - ------------------------- The Company is addressing the need to ensure that its operations will not be adversely impacted by software or other system failures related to year 2000. The Company's director of corporate systems has developed a plan to coordinate identification, evaluation and implementation of any necessary changes to internal computer systems, applications and business processes. The costs associated with this effort are expected to be incurred through 1999 and are not expected to have a material impact on the results of operations, cash flows or financial condition in any given year. However, no assurances can be given that the Company will be able to completely identify or address all year 2000 compliance issues, or that third parties with whom the Company does business will not experience system failures as a result of the year 2000 issues, nor can the Company fully predict the consequences of noncompliance. The Company has reviewed all of its software products for sale and determined them to be year 2000 compliant and accordingly does not believe it will be adversely impacted by year 2000 issues as it relates to its own products for sale. 9 FINANCIAL CONDITION Working capital, at May 31, 1998 was $2,041,244 with a current ratio of 3.9:1 compared to $1,794,909 with a current ratio of 3.3:1, at August 31, 1997. Net cash provided by operations for the nine months ended May 31, 1998 and 1997 was $827,836 and 285,991, respectively. Improved collections and a higher profitability were the primary factors resulting in improved operating cash flow. Net cash used in investing activities for the first nine months of fiscal 1998 was $604,324 compared to $463,593 for the same period in fiscal 1997. Capitalized software development costs for new products and significant enhancement to existing products accounted for 59% and 51% of the cash used for investing activities in 1998 and 1997, respectively. During the first quarter of the current year, the Company borrowed $185,000 against its $800,000 line of credit for general operating purposes. The Company repaid $418,000 against the line of credit using cash from operations during the first six months of the current fiscal year. No borrowing was required during the current third quarter and at May 31, 1998, there was no balance outstanding against the line of credit. During the first nine months the Company entered into approximately $187,000 of capital lease obligations to obtain the necessary scanners to meet requirements under document conversion contracts. The Company believes that operating cash flow and the $800,000 operating line of credit will be adequate to meet its current obligations and current operating and capital requirements. The funding of long-term needs is dependent upon increased revenue and profitability and obtaining funds through outside debt and equity sources. The funding for long-term needs includes funding for increased product development, expanded sales and technical staff and adequate promotion of the Company and its products. PART II - OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K Reports on Form 8-K - ------------------- None Exhibits - -------- Exhibit No. Name of Exhibit 27	Financial Data Schedule as of and for the nine month period ending May 31, 1998. 10 SIGNATURES 	 In accordance with the requirements of the Exchange Act, the registrant caused the report to be signed on its behalf by the undersigned, thereunto duly authorized. TMS, Inc. June 29, 1998 /s/ Arthur D. Crotzer Date: ____________________ _______________________ Chief Executive Officer June 29, 1998 /s/ Deborah D. Mosier Date: ____________________ _______________________ Chief Financial Officer