FORM 10-Q
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 28, 1996
Commission file number 0-28352
TECHNOLOGY SERVICE GROUP, INC.
(Exact name of Registrant as specified in its charter)
Delaware 59-1637426
(State or other jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
20 Mansell Court East - Suite 200 30076
Roswell, Georgia (Zip Code)
(Address of principal executive offices)
(770)587-0208
(Registrant's Telephone Number,
including area code)
Indicate by check mark whether Registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities 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 __
At July 31, 1996, there were 4,690,000 shares of common stock, $.01 par value,
outstanding.
Page 1 of 26
Exhibit Index at Page 24
INDEX
Page
Number
PART I. FINANCIAL INFORMATION
Consolidated Balance Sheets at June 28, 1996
(unaudited) and March 29, 1996 3
Consolidated Statements of Operations for the
first quarter ended June 28, 1996 (unaudited) and
June 30, 1995 (unaudited) 4
Consolidated Statements of Cash Flows for the
first quarter ended June 28, 1996 (unaudited) and
June 30, 1995 (unaudited) 5
Consolidated Statement of Changes in Stockholders'
Equity for the first quarter ended June 28, 1996
(unaudited) 6
Notes to Consolidated Financial Statements 7
Management's Discussion and Analysis of
Financial Condition and Results of Operations 12
PART II. OTHER INFORMATION 22
2
PART I - FINANCIAL INFORMATION
TECHNOLOGY SERVICE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
June 28, March 29,
1996 1996
-------------- --------------
(Unaudited)
ASSETS
Current assets:
Cash $ 160,719 $ 19,787
Accounts receivable, less allowance for doubtful
accounts of $247,000 and $216,000 6,630,548 3,866,372
Inventories 9,749,222 8,658,669
Deferred tax asset 261,603 50,544
Prepaid expenses and other current assets 70,600 146,117
-------------- --------------
Total current assets 16,872,692 12,741,489
Property and equipment, net 2,039,855 2,198,625
Deferred tax asset 145,313 --
Other assets 3,919,287 4,693,650
-------------- --------------
$ 22,977,147 $ 19,633,764
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Bank overdraft $ 1,762,631 $ 1,002,403
Borrowings under revolving credit agreement 192,710 --
Current maturities under long-term debt and
capital lease obligations 66,444 118,444
Accounts payable 5,546,236 5,030,945
Income taxes payable 225,710 165,666
Deferred revenue 55,733 541,245
Accrued liabilities 1,192,150 1,472,379
Accrued restructuring charges 16,427 16,427
-------------- --------------
Total current liabilities 9,058,041 8,347,509
Borrowings under revolving credit agreement -- 1,093,735
Long-term debt and capital lease obligations 888,176 3,414,586
Notes payable to stockholders -- 2,800,000
Deferred revenue 375,000 375,000
Other liabilities 3,198 3,198
-------------- --------------
10,324,415 16,034,028
-------------- --------------
Commitments and contingencies -- --
Stockholders' equity:
Preferred stock, $100 par value, 100,000 authorized,
none issued or outstanding -- --
Common stock, $.01 par value, 10,000,000 shares authorized,
4,690,000 and 3,500,000 shares issued and outstanding 46,900 35,000
Capital in excess of par value 11,922,944 3,465,000
Retained earnings 696,870 111,790
Cumulative translation adjustment (13,982) (12,054)
-------------- --------------
Total stockholders' equity 12,652,732 3,599,736
-------------- --------------
$ 22,977,147 $ 19,633,764
============== ==============
The accompanying notes are an integral part
of these consolidated financial statements.
3
TECHNOLOGY SERVICE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
First Quarter Ended
-----------------------------------------
June 28, June 30,
1996 1995
----------------- -----------------
Net sales $ 12,078,496 $ 6,354,145
----------------- -----------------
Costs and expenses:
Cost of goods sold 9,840,449 5,295,127
General and administrative expenses 644,985 534,358
Marketing and selling expenses 361,478 264,724
Engineering, research and
development expenses 409,095 286,429
Litigation settlement (105,146) --
Interest expense 141,540 206,585
Other (income) expense (16,187) (2,420)
----------------- -----------------
11,276,214 6,584,803
----------------- -----------------
Income (loss) before income tax
expense 802,282 (230,658)
Income tax provision (217,202) --
----------------- -----------------
Net income (loss) $ 585,080 $ (230,658)
================= =================
Income (loss) per common and
common equivalent share $ 0.13 $ (0.06)
================= =================
Weighted average number of common and
common equivalent shares outstanding 4,501,732 3,805,625
================= =================
The accompanying notes are an integral part
of these consolidated financial statements.
4
TECHNOLOGY SERVICE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
First Quarter Ended
-----------------------------------------
June 28, June 30,
1996 1995
----------------- -----------------
Cash flows from operating activities
Net income (loss) $ 585,080 $ (230,658)
Adjustments to reconcile net income (loss) to net
cash provided by (used for) operating activities
Depreciation and amortization 287,973 242,812
Provisions for inventory losses and
warranty expense 172,942 40,895
Provision for uncollectible accounts receivable 30,882 15,873
Provision for deferred tax benefits (45,390) --
Changes in certain assets and liabilities
(Increase) in accounts receivable (2,795,058) (743,699)
(Increase) in inventories (1,203,069) (40,214)
Decrease in prepaid expenses and other
current assets 75,517 11,326
(Increase) in other assets (12) (601)
Increase in accounts payable 515,291 376,436
Increase in income taxes payable 113,549 --
(Decrease) in deferred revenue (485,512) --
(Decrease) in accrued liabilities (340,655) (156,361)
(Decrease) in accrued restructuring charges -- (72,000)
Other (633) (1,620)
----------------- -----------------
Net cash used for operating activities (3,089,095) (557,811)
----------------- -----------------
Cash flows from investing activities
Capital expenditures (58,981) (120,239)
----------------- -----------------
Net cash used for investing activities (58,981) (120,239)
----------------- -----------------
Cash flows from financing activities
Net proceeds (payments) under revolving
credit agreement (901,025) 411,840
Proceeds from initial public offering, net of
issuance expenses 8,648,215 --
Proceeds from exercise of common stock
purchase warrants 160,000 --
Repayment of notes payable to stockholders (2,800,000) --
Principal payments on long-term debt and
capital lease obligations (2,578,410) (229,102)
Increase in bank overdraft 760,228 381,143
----------------- -----------------
Net cash provided by financing activities 3,289,008 563,881
----------------- -----------------
Increase (decrease) in cash 140,932 (114,169)
Cash, beginning of period 19,787 265,576
----------------- -----------------
Cash, end of period $ 160,719 $ 151,407
================= =================
The accompanying notes are an integral part
of these consolidated financial statements.
5
TECHNOLOGY SERVICE GROUP, INC.
STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE FIRST QUARTER ENDED JUNE 28, 1996
(Unaudited)
Capital in Cummulative
Common Excess of Retained Translation
Stock Par Value Earnings Adjustment Total
-------------- ---------------- ------------- ---------------- --------------
Balance at March 29, 1996 $ 35,000 $ 3,465,000 $ 111,790 $ (12,054) $ 3,599,736
Issuance of 1,150,000 shares in
initial public offering, net of
issuance expenses 11,500 8,298,344 -- -- 8,309,844
Issuance of 40,000 shares upon
exercise of common stock
purchase warrants 400 159,600 -- -- 160,000
Net income for the period -- -- 585,080 -- 585,080
Foreign currency translation
adjustment -- -- -- (1,928) (1,928)
-------------- ---------------- ------------- ------------- --------------
Balance at June 28, 1996 $ 46,900 $ 11,922,944 $ 696,870 $ (13,982) $ 12,652,732
============== ================ ============= ============= ==============
The accompanying notes are an integral part
of these consolidated financial statements.
6
TECHNOLOGY SERVICE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. GENERAL
The accompanying unaudited consolidated balance sheet of the Company as of
June 28, 1996 and the unaudited consolidated statements of operations, of
changes in stockholders equity, and cash flows for the quarters ended June 28,
1996 and June 30, 1995 have been prepared in accordance with instructions to
Form 10-Q. Accordingly, the financial information does not include all the
information and footnotes required by generally accepted accounting principles
for complete financial statements. In the opinion of management, all
adjustments, consisting only of normal recurring accruals and adjustments,
necessary for a fair presentation of the financial position of the Company at
June 28, 1996 and its operations and its cash flows for the quarters ended June
28, 1996 and June 30, 1995 have been made. For further information, refer to the
audited financial statements and footnotes included in the Company's annual
report on Form 10-K for the fiscal year ended March 29, 1996.
The results of operations for the first quarter ended June 28, 1996 are not
necessarily indicative of the results for the entire fiscal year ending March
28, 1997.
2. INVENTORIES
Inventories at June 28, 1996 and March 29, 1996 consisted of the following:
June 28, March 29,
1996 1996
--------------- ----------------
Raw materials $ 6,598,416 $ 6,056,702
Work-in-process 1,689,367 1,207,080
Finished goods 1,461,439 1,394,887
--------------- ----------------
$ 9,749,222 $ 8,658,669
=============== ================
3. BORROWINGS UNDER REVOLVING CREDIT AGREEMENT, LONG-TERM DEBT, CAPITAL LEASE
OBLIGATIONS AND NOTES PAYABLE TO STOCKHOLDERS
At June 28, 1996, the Company is able to borrow up to a maximum of $9
million under a revolving credit agreement pursuant to the terms of a Loan and
Security Agreement (the "Loan Agreement") between the Company and its bank. At
June 28, 1996 and March 29, 1996, the Company had outstanding debt of $192,710
and $1,093,735, respectively, under the revolving credit agreement. At March 29,
1996, the Company also had outstanding debt of $2,525,000 under term and
installment notes issued pursuant to the terms of the Loan Agreement.
Indebtedness outstanding under the Loan Agreement is secured by substantially
all assets of the Company including accounts receivable, inventories and
property and equipment. At June 28, 1996, the borrowing limit under the
revolving credit agreement was based upon specified percentages applied to the
value of collateral, consisting of accounts receivable and inventories, and
varies based upon changes in the collateral value. At March 29, 1996, the
borrowing limit under the revolving credit agreement was based upon specified
percentages applied to the value of collateral less indebtedness outstanding
under a $2.2 million term note due November 30, 1997. Interest is payable
monthly at a variable rate per annum equal to 1-1/2% above a base rate quoted by
Citibank (8.25% at June 28, 1996 and March 29, 1996).
7
In May 1996, the Company completed an initial public offering of equity
securities (see Note 4). A portion of the proceeds from the initial public
offering was used to repay the Company's then outstanding indebtedness of
$2,509,524 pursuant to the term and installment notes. In addition, a portion of
the proceeds was used to repay $3,808,589 of indebtedness outstanding under the
revolving credit agreement. Accordingly, the Company classified $1,093,735 of
indebtedness outstanding under the revolving credit facility and $2,509,524 of
indebtedness outstanding under term and installment notes at March 29, 1996 as
long-term obligations.
Long-term debt and capital lease obligations payable at June 28, 1996 and
March 29, 1996 consisted of the following:
June 28, March 29,
1996 1996
--------------- --------------
Loan and Security Agreement
$2.2 million secured term note, principal
balance due November 30, 1997 $ - $ 2,200,000
$650,000 secured term note, principal
payable in sixty equal monthly installments
of $7,738, with remaining principal balance
due November 30, 1997 - 325,000
Unsecured non-interest bearing promissory
note, payable in nineteen equal monthly
installments of $10,873 - 32,620
Obligations under capital leases 954,620 975,410
--------------- --------------
954,620 3,533,030
Less - current maturities (66,444) (118,444)
--------------- --------------
$ 888,176 $ 3,414,586
=============== ==============
On October 31, 1994, the Company entered into an Investment Agreement.
Pursuant to the terms of the Investment Agreement, the Company borrowed $2.8
million from stockholders and issued subordinated promissory notes due November
30, 1999 that bear interest at a rate of 10% per annum. In May 1996, the Company
repaid the outstanding indebtedness pursuant to the subordinated promissory
notes from the proceeds of its initial public offering.
4. STOCKHOLDERS' EQUITY
Initial Public Offering
In May 1996, the Company completed an initial public offering of 1,150,000
units (the "Units"), each Unit consisting of one share of common stock and one
redeemable warrant ("Redeemable Warrant") at a price of $9.00 per Unit for gross
proceeds of $10,350,000. In connection with the offering, the Company issued
warrants to the Underwriters to purchase 100,000 shares of Common Stock (the
"Underwriter Warrants") for gross proceeds of $10. Net proceeds received by the
Company, after underwriting discounts and expenses of $1,231,897 and other
expenses of $808,269, amounted to $8,309,844. As of March 29, 1996, the Company
had incurred, and deferred as other assets, offering expenses of $338,372.
Accordingly, net proceeds during the quarter ended June 28, 1996 amounted to
$8,648,215.
8
Two Redeemable Warrants entitle the holder thereof to purchase one share of
common stock at an exercise price of $11.00 per share. Unless the Redeemable
Warrants are redeemed, the Redeemable Warrants may be exercised at any time
beginning on May 10, 1996 and ending May 9, 1999, at which time the Redeemable
Warrants will expire. Beginning on February 10, 1997, the Redeemable Warrants
are redeemable by the Company at its option, as a whole and not in part, at $.05
per Redeemable Warrant on 30 days' prior written notice, provided that the
average closing bid price of the common stock equals or exceeds $12.00 per share
for 20 consecutive trading days ending within five days prior to the date of the
notice of redemption. The Redeemable Warrants will be entitled to the benefit of
adjustments in the exercise price and in the number of shares of common stock
deliverable upon the exercise thereof upon the occurrence of certain events,
including a stock dividend, stock split or similar reorganization.
The Underwriter Warrants are initially exercisable at a price of $10.80 per
share of common stock. The Underwriter Warrants contain anti-dilution provisions
providing for adjustments of the number of warrants and exercise price under
certain circumstances. The Underwriter Warrants grant to the holders thereof
certain rights of registration of the securities issuable upon exercise of the
Underwriter Warrants. The Underwriter Warrants may be exercised at any time
beginning on May 10, 1997 and ending May 9, 2001, at which time the Underwriter
Warrants will expire.
Common Stock Purchase Warrants
On May 23, 1995, the Company issued a warrant to one of its contract
manufacturers to purchase 40,000 shares of common stock, $.01 par value, at a
price of $4.00 per share in return for the extension of credit under the terms
of a manufacturing agreement between the Company and the contract manufacturer.
On June 17, 1996, the warrant was exercised and the Company issued 40,000 shares
of common stock for aggregate proceeds of $160,000.
Income (Loss) Per Common and Common Equivalent Share
Income (loss) per common and common equivalent share for the quarters ended
June 28, 1996 and June 30, 1995 is computed on the basis of the weighted average
number of common shares outstanding and dilutive common stock equivalent shares
outstanding during the period, except pursuant to the Securities and Exchange
Commission Staff Accounting Bulletin ("SECSAB") Topic 4:D, shares of common
stock underlying warrants issued and options granted during the 12 months prior
to the Company's May 10, 1996 initial public offering (see Note 4) at prices
below the public offering price have been included in the calculation of
weighted average shares of common and common equivalent shares outstanding as if
they were outstanding as of the beginning of the periods presented. Fully
diluted income (loss) per common and common equivalent share is not materially
different from primary income (loss) per common and common share.
9
5. INCOME TAXES
There was no provision for income taxes for the quarter ended June 30,
1995. The provision for income taxes charged to operations for the quarter ended
June 28, 1996 was as follows:
Current tax expense:
Federal $ 272,870
State 41,114
--------------
313,984
--------------
Deferred tax benefit:
Federal (161,839)
State (22,609)
--------------
(184,448)
--------------
129,536
Tax benefits of operating loss carryforwards (71,995)
Tax benefits applied to goodwill 159,663
--------------
$ 217,204
==============
The provision for income taxes differs from the amount of income taxes
determined by applying the applicable U.S. statutory federal income tax rate to
income (loss) before income taxes as a result of the following differences:
First Quarter Ended
-------------------------------
June 28, June 30,
1996 1995
------------- -------------
Statutory U.S. tax rates $ 272,776 $ (78,423)
State taxes, net of federal benefit 26,276 -
Non-deductible expenses 14,932 25,721
Losses for which no tax benfit was
provided - 52,702
Utilization of loss carryforwards (71,995)
Net deferred tax benefits (24,785) -
-------------- -------------
Effective tax rates $ 217,204 $ -
============== =============
10
6. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information for the quarters ended June 28, 1996 and
June 30, 1995 consists of the following:
First Quarter Ended
--------------------------------
June 28, June 30,
1996 1995
-------------- -----------
Interest paid $ 284,035 $ 287,945
Income taxes paid 149,044 -
Deferred offering expenses charged against
proceeds of initial public offering 338,372 -
Realization of deferred tax assets applied to
goodwill 159,663 -
Other current assets acquired by assumption
of debt obligation - 131,594
Write-off of property and equipment against
accounts payable - 1,600
In addition, during the quarter ended June 28, 1996, the Company applied
$151,318 of deferred tax benefits to goodwill with respect to acquired deferred
tax assets as of March 29, 1996 as a result a reassessment of the realizability
thereof.
7. COMMITMENTS AND CONTINGENT LIABILITIES
Pursuant to the terms of a settlement agreement and mutual release dated
July 3, 1996, a suit filed against the Company by a former supplier to collect
approximately $400,000 of unpaid obligations was dismissed with prejudice.
Pursuant to the terms of the settlement agreement, the Company paid $180,000 and
agreed to pay an additional $112,500 in six equal monthly installments of
$18,750 commencing on August 15, 1996. As a result of the settlement agreement
the Company realized a gain of $105,146 representing the difference between
unpaid obligations recorded in the Company's accounts and aggregate settlement
payments set forth in the settlement agreement. The gain is reflected in the
Company's results of operations for the quarter ended June 28, 1996.
11
TECHNOLOGY SERVICE GROUP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Forward Looking Statements
This report contains certain forward looking statements concerning the
Company's operations, economic performance and financial condition. Such
statements are subject to various risks and uncertainties. Actual results could
differ materially from those currently anticipated due to a number of factors,
including those identified herein.
Results of Operations
For the Quarter Ended June 28, 1996 Compared to the Quarter Ended June 30, 1995
Overview. The Company generated income before taxes of $802,282 during the
quarter ended June 28, 1996 as compared to a net loss of $230,658 during the
quarter ended June 30, 1995. Net income for the quarter ended June 28, 1996
amounted to $585,080, or $.13 per share as compared to a loss of ($.06) per
share for the corresponding quarter last year.
Sales. Sales increased by $5,724,351, or 90%, to $12,078,496 for the
quarter ended June 28, 1996 (first quarter of fiscal 1997) from $6,354,145 for
the quarter ended June 30, 1995 (first quarter of fiscal 1996). The increase in
sales is primarily attributable to an increase in sales volume, particularly
sales that related to smart payphone products and components. Sales of smart
payphone products and components increased by approximately $5.1 million (257%),
and accounted for approximately 69% of sales during the first quarter of fiscal
1997 as compared to 51% of sales during the first quarter of fiscal 1996.
Refurbishment and repair services and related product sales for the first
quarter of fiscal 1997 increased by approximately $798,000 (27%) as compared to
the same period last year, and accounted for 31% of sales as compared to 47%
last year. Sales during the first quarter of fiscal 1997 do not reflect any
export sales. Export sales for the first quarter of fiscal 1996 accounted for
approximately 2% of the Company's sales.
A significant portion of the Company's sales during the first quarter of
fiscal 1997 were attributable to shipments pursuant to a sales agreement between
the Company and NYNEX Corp. ("NYNEX") executed in December 1995. During the
first quarter of fiscal 1996, a significant portion of the Company's sales were
attributable to shipments pursuant to a sales agreement between the Company and
Southwestern Bell Telephone Company ("SWB") executed in December 1994. Sales
volume during the first quarter of fiscal 1995, however, was adversely affected
by a recall of smart products initiated by the Company as a result of potential
product failures that could result from contamination introduced into the
manufacturing process by the Company's contract manufacturer. See "Liquidity and
Capital Resources - Operating Trends and Uncertainties," below for a discussion
of the Company's dependence on significant customers and contractual
relationships and for further information concerning the recall.
Cost of Goods Sold. Cost of goods sold increased by $4,545,322, or 86%, to
$9,840,449 during the first quarter of fiscal 1997 as compared to $5,295,127
during the first quarter of fiscal 1996. The increase in cost of products sold
is primarily attributable to the 90% increase in sales during the first quarter
of fiscal 1997 as compared to the first quarter of fiscal 1996. Although certain
sales price reductions and variations in product mix had an adverse impact on
product margins, the increase in volume had a favorable impact on production
costs as a percentage of sales. Overall, cost of goods sold as a percentage of
sales declined to 81% during the first quarter of fiscal 1997 as compared to 83%
of sales during first quarter of fiscal 1996.
12
General and Administrative Expenses. General and administrative expenses
increased by $110,627, or 21%, to $644,985 (5% of sales) during the first
quarter of fiscal 1997 from $534,358 (8% of sales) during the first quarter of
fiscal 1996. The increase in general and administrative expenses is primarily
related to the increase in the volume of business, amortization of deferred
patent license fees with respect to a patent license acquired in September 1995,
legal fees associated with litigation settled on July 3, 1996 (see "Litigation
Settlement," below) and bonus compensation accrued pursuant to the terms of the
employment agreement between the Company and its president.
Marketing and Selling Expenses. Marketing and selling expenses increased by
$96,754, or 37%, to $361,478 (3% of sales) during the first quarter of fiscal
1997 as compared to $264,724 (4% of sales) during the first quarter of fiscal
1996. The increase is primarily attributable to an increase in royalty expense
associated with the increase in sales of smart payphone products. The royalty
agreement covering the Company's smart payphone products expired on June 30,
1996.
Engineering, Research and Development Expenses. Engineering, research and
development expenses increased by $122,666, or 43%, to $409,095 (3% of sales)
during the first quarter of fiscal 1997 as compared to $286,429 (5% of sales)
during the first quarter of fiscal 1996 primarily due to an expansion of
engineering resources and product development activities. The Company began to
expand its engineering resources during the first quarter of fiscal 1997 in
order to facilitate smart product development activities and the implementation
of lower-cost manufacturing methodologies.
Litigation Settlement. Pursuant to the terms of a settlement agreement and
mutual release dated July 3, 1996, a suit filed against the Company by a former
supplier to collect approximately $400,000 of unpaid obligations was dismissed
with prejudice. As a result of the settlement agreement, the Company realized a
gain of $105,146 representing the difference between unpaid obligations recorded
in the Company's accounts and aggregate settlement payments set forth in the
settlement agreement.
Interest Expense. Interest expense decreased to $141,540 during the first
quarter of fiscal 1997 as compared to $206,585 during the first quarter of
fiscal 1996 primarily due to the repayment of outstanding bank and stockholder
debt obligations during May 1996 from proceeds of the Company's initial public
offering. See "Liquidity and Capital Resources - Cash Flows From Financing
Activities," below.
Income Taxes. During the first quarter of fiscal 1997, the Company recorded
an income tax provision of $217,202 on pre-tax income of $802,282, which
resulted in net income of $585,080. Benefits of net operating loss carryforwards
used to offset current taxable income during the quarter amounted to $71,995.
Benefits of acquired deferred tax assets aggregating $159,663, including
benefits of acquired net operating loss carryforwards, were applied to goodwill.
There was no tax provision during first quarter of fiscal 1996 as a result of
the reported net loss of $230,658.
13
Liquidity and Capital Resources
Initial Public Offering
During May 1996, the Company completed an initial public offering of
1,150,000 Units, each Unit consisting of one share of Common Stock and a
Redeemable Warrant, at a price of $9.00 per Unit for gross proceeds of
$10,350,000. Net proceeds received by the Company, after underwriting discounts
and expenses of $1,231,887 and other expenses of $808,269, aggregated
$8,309,844. As of March 29, 1996, the Company had incurred and deferred offering
expenses of $338,372. Accordingly, net proceeds from the Company's initial
public offering during the first quarter of fiscal 1997 aggregated $8,648,215.
The net proceeds of the offering were initially used to repay then
outstanding indebtedness consisting of subordinated notes payable to
stockholders of $2.8 million and bank indebtedness aggregating $6,318,113 (see
"Cash Flows From Financing Activities," below). Indebtedness pursuant to the
Loan Agreement between the Company and its bank repaid with the net proceeds
consisted of a $2.2 million term note due November 30, 1997, $309,524
outstanding under a $650,000 term note due November 30, 1997 and borrowings
under a revolving credit agreement of $3,808,589.
The Loan Agreement
The Loan Agreement between the Company and its bank provides financing to
the Company under a revolving credit agreement and term and installment notes of
up to $9 million. Pursuant to an October 31, 1994 amendment to the Loan
Agreement, $2.2 million of debt outstanding under the revolving credit agreement
was converted into a term note payable on November 30, 1997, the interest rate
on amounts borrowed under the terms of the Loan Agreement was reduced by 3/4%
and the term of the Loan Agreement was extended from May 31, 1995 to November
30, 1997. At March 29, 1996, the Company had borrowed an aggregate of $1,093,735
under the revolving credit agreement and $2,525,000 under term and installment
notes, including the $2.2 million term note due November 30, 1997. At March 29,
1996, the term and installment notes consisted of a term note with an
outstanding balance of $2.2 million and a term note with an outstanding balance
of $325,000. At June 28, 1996, the Company has borrowed an aggregate of $192,710
under the revolving credit agreement after repayments from proceeds of the
initial public offering. As of June 28, 1996, outstanding indebtedness under the
Loan Agreement bears interest at a variable rate per annum equal to 11/2% above
a base rate quoted by Citibank, N.A. The interest rate was reduced from 2% above
a base rate quoted by Citibank, N.A. on March 1, 1996. The base rate at June 28,
1996 and March 29, 1996 was 81/4% per annum. Amounts borrowed under the Loan
Agreement are secured by substantially all assets of the Company, including
accounts receivable, inventories and property and equipment. The Loan Agreement
expires on November 30, 1997, and is renewable annually for one-year periods
unless terminated by the bank upon an occurrence of an event of default or by
the Company upon at least 90 days notice.
The Loan Agreement contains conditions and covenants that prevent or
restrict the Company from engaging in certain transactions without the consent
of the bank, including merging or consolidating, payment of subordinated
stockholder debt obligations, declaration or payment of dividends, and
disposition of assets, among others. Additionally, the Loan Agreement requires
the Company to comply with specific financial covenants, including covenants
with respect to cash flow, working capital and net worth. Noncompliance with any
of these conditions and covenants or the occurrence of an event of default, if
not waived or corrected, could accelerate the maturity of the borrowings
outstanding under the Loan Agreement. Although the Company is in compliance with
the covenants set forth in the Loan Agreement as of June 28, 1996, there is no
assurance that the Company will be able to remain in compliance with such
covenants in the future.
The Company used the net proceeds of its initial public offering to repay
outstanding indebtedness under the Loan Agreement in order to reduce its
interest expense. The Company intends to use the financing available under the
Loan Agreement to finance its on-going working capital needs. If an event of
default under the existing working capital facility were to occur, however, the
14
Company's ability in this regard could be curtailed. In such event, the Company
would seek alternative financing sources.
Cash Flows From Financing Activities
Cash provided by financing activities during the first quarter of fiscal
1997 aggregated $3,289,008, including the net proceeds from the Company's
initial public offering of $8,648,215, as compared to $563,881 during the first
quarter of fiscal 1996.
Pursuant to an October 31, 1994 Investment Agreement, the Company borrowed
$2.8 million from its stockholders, and issued subordinated promissory notes due
November 1, 1999 that bear interest at a rate of 10% per annum. These
subordinated promissory notes were repaid in May 1996 from the proceeds of the
Company's initial public offering.
Net payments of indebtedness under the Company's revolving credit agreement
during the first quarter of fiscal 1997 amounted to $901,025 as compared to net
proceeds of $411,840 during the first quarter of fiscal 1996. During the quarter
ended June 28, 1996, the Company repaid $3,808,589 of revolving credit
indebtedness from the proceeds of its initial pubic offering. Exclusive of such
repayment, the net proceeds under the revolving credit agreement during the
first quarter of fiscal 1997 aggregated $2,907,564. The amounts borrowed under
the revolving credit agreement during the first quarter of fiscal 1997,
exclusive of repayments from the initial public offering, and the first quarter
of fiscal 1996 were used to fund increases in accounts receivable and
inventories of $3,998,127 and $783,913, respectively.
Principal payments on other debt and capital lease obligations during the
first quarter of fiscal 1997 aggregated $2,578,410 including repayment of the
$2.2 million term note due November 30, 1997 and the repayment of $309,524
outstanding under the $650,000 term note due November 30, 1997 from the proceeds
of the Company's initial public offering. Principal payments on other debt and
capital lease obligations during the first quarter of fiscal 1996 aggregated
$229,192.
The Company has also established a cash management program with its bank
pursuant to which the Company funds drafts as they clear the bank. Accordingly,
the Company maintains bank overdrafts representing outstanding drafts and
utilizes the cash management account as a source of funding. During the first
quarter of fiscal 1997, the Company's bank overdrafts increased by $760,228 as
compared to an increase of $381,143 during the first quarter of fiscal 1996.
In June 1996, the Company issued 40,000 shares of common stock for
aggregate proceeds of $160,000 upon the exercise of outstanding common stock
purchase warrants issued in May 1995. See "Capital Commitments and Liquidity,"
below.
Cash Flows From Operating Activities
Cash used to fund operating activities during the first quarter of fiscal
1997 amounted to $3,089,095 as compared to $577,811 during the first quarter of
fiscal 1996. Cash provided by operations, net of non-cash charges, increased to
$1,031,487 during the first quarter of fiscal 1997 from $68,922 during the first
quarter of fiscal 1996 primarily due to the improved operating results. Cash
used to fund increases in accounts receivable and inventories during the first
quarter of fiscal 1997 amounted to $3,998,127 as compared to $783,913 during the
first quarter of fiscal 1996. The increase in accounts receivable during the
first quarters of fiscal 1997 and 1996 of $2,795,058 and $743,699, respectively,
was primarily attributable to increases in the volume of business. Inventories
increased by $1,203,069 during the first quarter of fiscal 1997 as compared to
$40,214 during the first quarter of fiscal 1996. The growth in inventories
during the first quarter of fiscal 1997, although partially related to the
volume of business, is primarily attributable to an excess of purchase
commitments over sales requirements as a result of a change in the delivery
requirements of one of the Company's customers (see "Capital Commitments and
Liquidity," below). Cash provided by increases in accounts payable amounted to
$515,291 and $376,436 during the first quarters of fiscal 1997 and 1996,
respectively. Such increases are related to the volume of business. Cash
15
resources during each of such quarters were adequate to meet the Company's
non-disputed obligations as they became due. During the first quarter of fiscal
1997, the Company used $485,512 of cash to reduce its deferred revenue
obligations existing at March 29, 1996. During the first quarter of fiscal 1996,
no such obligations existed. The Company used $340,655 of cash to reduce its
accrued liability obligations during the first quarter of fiscal 1997 as
compared to $228,361 (including accrued restructuring charges) during the first
quarter of fiscal 1996. During the first quarter of fiscal 1997, the Company
paid executive bonuses of approximately $71,000 accrued at March 29, 1996
pursuant to the employment agreement between the Company and its president and
paid accrued interest of $151,891 in connection with the repayment of the
subordinated stockholder notes. During the first quarter of fiscal 1996, the
Company paid accrued restructuring charges of $72,000 primarily consisting of a
lease termination settlement with respect to a closed facility.
Cash Flows From Investing Activities
Cash used to fund investing activities during the first quarter of fiscal
1997 amounted to $58,981 as compared to $120,239 during the first quarter of
fiscal 1996. During the first quarter of fiscal 1996, the Company expanded its
investment in automated test equipment located at its contract manufacturer.
During the first quarter of fiscal 1997, the Company began a program to upgrade
its in-house testing capability, and expects an increase in its capital
expenditures over the next several quarters (see "Capital Commitments and
Liquidity," below).
Capital Commitments and Liquidity
The Company has not entered into any significant commitments for the
purchase of capital assets. However, the Company intends to purchase and install
information systems and capital equipment, including printed circuit board
assembly equipment and other manufacturing equipment, to advance its prototype
manufacturing and product testing capabilities during the eighteen months
following the date of the Company's initial public offering. In addition, the
Company intends to expand its manufacturing capabilities through the purchase of
capital equipment in the future as required to meet the needs of its business.
The Company expects to expend approximately $800,000 to fund anticipated capital
expenditures during the eighteen month period following the initial public
offering. However, there can be no assurance that capital expenditures will be
made as planned or that additional capital expenditures will not be required.
The Company believes, based on its current plans and assumptions relating to its
operations, that its sources of capital, including capital available under its
revolving credit line and cash flow from operations will be adequate to satisfy
its anticipated cash needs, including anticipated capital expenditures, for at
least the next year. However, in the event that the Company's plans or the basis
for its assumptions change or prove to be inaccurate, or cash flow and sources
of capital prove to be insufficient to provide for the Company's cash
requirements (due to unanticipated expenses, loss of sales revenues, problems,
operating difficulties or otherwise), the Company would be required to seek
additional financing. In such an event, there can be no assurance that
additional financing will be available to the Company on commercially reasonable
terms, or at all.
Extension of credit to customers and inventory purchases represent the
principal working capital requirements of the Company, and significant increases
in accounts receivable and inventory balances could have an adverse effect on
the Company's liquidity. The Company's accounts receivable, less allowances for
doubtful accounts, at June 28, 1996 and March 29, 1996 amounted to $6,630,548
and $3,866,372, respectively. Accounts receivable at June 28, 1996 and March 29,
1996 consists primarily of amounts due from the RBOCs. The Company's
inventories, less allowances for potential losses due to obsolescence and excess
quantities amounted to $9,749,222 and $8,658,669 at June 28, 1996 and March 29,
1996, respectively. The level of inventory maintained by the Company is
dependent on a number of factors, including delivery requirements of customers,
availability and lead-time of components and the ability of the Company to
estimate and plan the volume of its business. The Company markets a wide range
of services and products and the requirements of its customers vary
significantly from period to period. Accordingly, inventory balances may vary
significantly.
16
In October 1994, the Company entered into a contract manufacturing
agreement that provides for the production of certain smart payphone processors.
Pursuant to the terms of the manufacturing agreement, the Company committed to
purchase $12.2 million of product over an eighteen-month period beginning in
December 1994. In addition, in November 1994, the Company entered into a dealer
agreement that commits the Company to purchase approximately $3.5 million of
electronic lock devices over a two-year period. Purchases under the terms of
these agreements fluctuate based on delivery requirements established by the
Company. The Company initially scheduled purchases pursuant to these agreements
based on anticipated quantities required to meet its sales commitments. As of
June 28, 1996, the Company had acquired the majority of committed purchase
volume pursuant to these purchase agreements. However, the Company presently
anticipates that scheduled purchases through December 1996 will exceed sales
requirements as a result of changes in delivery requirements of one of the
Company's customers. Although the Company is encouraging its customer to
accelerate purchases and is seeking to reschedule deliveries pursuant to such
agreements, an increase in inventories related to such agreements is anticipated
during the first three quarters of fiscal 1997 and such increase could
approximate, in the aggregate, as much as $2.0 million.
During October 1994, the Company, its bank and a contract manufacturer
entered into an escrow agreement as security for the payment of the Company's
obligations to the contract manufacturer. In May 1995, the Company issued common
stock purchase warrants (which were exercised during the first quarter of fiscal
1997) that provided the contract manufacturer with the right to purchase 40,000
shares of the Company's common stock at a price of $4.00 per share for a period
of five years in return for extension of credit of $1.5 million and 45-day
payment terms to the Company. This agreement had a significant favorable impact
on the Company's liquidity. However, if the Company defaults with respect to the
payment terms, the Company will be required to utilize the escrow account
previously established, which could have a significant adverse effect on the
Company's liquidity.
In December 1994, the Company sold the rights to certain product software
for an aggregate purchase price of $500,000. The Company received back an
exclusive irrevocable perpetual right to sublicense the software in connection
with the sale of related products. In return, the Company agreed to pay
royalties on sales of licensed products to other customers. Such royalties would
be payable commencing if, and only if, laws, regulations or judicial actions
occur which would permit the purchaser of the software to receive such royalty
payments. The Company is obligated to repay, three years from the date of sale,
a portion of the purchase price up to a maximum amount of $375,000, which is
reflected as deferred revenue in the Company's consolidated financial statements
at June 28, 1996 and March 29, 1996. The actual amount of any repayment is
dependent upon the amount of aggregate royalties paid pursuant to the license
agreement during such three-year period. The amount of repayment will equal: (i)
$375,000 if aggregate royalties paid amount to less than $125,000; (ii) $250,000
if aggregate royalties paid are greater than $125,000 but less than $250,000; or
(iii) $125,000 if aggregate royalties paid are greater than $250,000 but less
than $375,000. If aggregate royalties paid during the first three years of the
agreement exceed $375,000, the Company is not required to repay any portion of
the purchase price. As of June 28, 1996, the Company is not obligated to pay and
has not paid any royalties under the agreement.
Operating Trends and Uncertainties
Dependence on Customers and Contractual Relationships
The Company markets its payphone products and services predominately to the
RBOCs. In fiscal years 1994, 1995 and 1996, sales to RBOCs accounting for
greater than 10% of the Company's sales aggregated 73%, 72% and 88%,
respectively, of the Company's sales revenues. The Company's significant
customers during the past three years have included Ameritech Services, Inc.,
Bell Atlantic Corp. ("Bell Atlantic"), BellSouth Telecommunications, Inc.,
Southwestern Bell Telephone Company ("SWB") and NYNEX Corp. ("NYNEX"). During
the quarter ended June 28, 1996, Ameritech Services, Inc. Bell Atlantic, NYNEX
and SWB accounted for approximately $1.2 million, $1.4 million, $8.1 million and
17
$1.2 million, respectively, of the Company's sales. During the quarter ended
June 30, 1995, Bell Atlantic, NYNEX and SWB accounted for approximately $1.5
million, $622,000 and $3.1 million, respectively, of the Company's sales.
The Company anticipates that it will continue to derive most of its
revenues from such customers, and other regional telephone companies, for the
foreseeable future. The loss of any one of such RBOC customers or a significant
reduction in sales volume or sales prices to such RBOCs would have a material
adverse effect on the Company's business. Recently, two mergers between Pacific
Telesis Inc. and SBC Communications, Inc. (the parent of SWB), and between Bell
Atlantic and NYNEX were announced. The Company cannot predict the impact that
such mergers or other future mergers will or may have on the Company's business.
The Company competes for and enters into non-exclusive supply contracts to
provide products, components and services to the RBOCs. The Company has entered
into sales agreements to provide smart products to Ameritech Services, Inc. and
U.S. West. The Company has entered into sales agreements to provide payphone
components to Ameritech Services, Inc., BellSouth Telecommunications, Inc., Bell
Atlantic, NYNEX and SWB. The Company has entered into sales agreements to
provide repair, refurbishment and conversion services to Ameritech Services,
Inc., Bell Atlantic, NYNEX and SWB. These agreements have terms ranging from two
to three years, are renewable at the option of and subject to the procurement
process of the particular RBOC, contain fixed sales prices for the Company's
products and services with limited provisions for cost increases and expire at
various dates from July 1996 to March 1999. These sales agreements are
frameworks for dealing on open account and do not specify or commit the
Company's customers to purchase a specific volume of products or services. If
orders are made, however, the Company has agreed to fill such orders in
accordance with the customer's contract specifications. The agreements are
generally subject to termination at the option of the customer upon 30 days
notice to the Company, or if the Company defaults under any material provision
of the agreement, including provisions with respect to performance. In addition,
as further described below, the Company has entered into sales agreements to
provide smart products to NYNEX and SWB. The terms of these sales agreements
(the "firm commitment sales agreements"), however, require the customers to
purchase specific quantities of smart products and other components from the
Company at specified prices, subject to the cancellation provisions thereof.
The Company's prospects for continued profitability are largely dependent
upon the RBOCs upgrading the technological capabilities of their installed base
of payphones, and utilizing the Company's products and services for such upgrade
conversion programs. To date, the Company believes that one of the RBOCs has
completed a technological upgrade program for its installed base of payphones
and that two of the RBOCs have commenced such a program. The two RBOCs that have
commenced upgrade programs, and which are significant customers of the Company,
have entered into sales agreements with the Company as described below.
In December 1994, the Company entered into a sales agreement with SWB
pursuant to which the Company agreed to supply and SWB agreed to purchase $21.3
million of smart processors and other components, including electronic locks,
over a three-year period at specified prices. The agreement also includes a
"most favored customer" clause pursuant to which the Company has agreed to
provide price and other terms at least as favorable as those extended by the
Company to other customers for the products covered by the agreement. The
agreement contains certain covenants and conditions relating to product quality
and delivery requirements, among others. The agreement provides for penalties
and damages in the event that the Company is unable to comply with certain
performance criteria. Upon a default by the Company with respect to such
covenants and conditions, SWB has the right to cancel the agreement or reduce
its purchase commitment, provided such default is not cured within a 20-day
notice period. In addition, SWB may in any event terminate the agreement upon at
least 30 days notice. However, upon such a termination, SWB has agreed to
purchase all finished goods then held by the Company and to pay contractor and
supplier cancellation and restocking charges, if any, plus a nominal profit
percentage above the cost of such materials. Because SWB has the right to
terminate the contract on 30 days notice as described above, there can be no
assurance that the Company will ultimately sell $21.3 million of smart
processors and other components pursuant to such contract. As of June 28, 1996,
the Company estimates that the customer has acquired in excess of 65% of
18
committed volume under such sales agreement. However, as a result of changes in
SWB's delivery requirements, the Company does not anticipate shipping the
remaining volume pursuant to the terms of the agreement during the remainder of
the 1996 calendar year.
In December 1995, the Company entered into an amendment to a sales
agreement with NYNEX pursuant to which the Company agreed to supply and NYNEX
agreed to purchase approximately $12 million of smart products and other
components over a eight-month period at specified prices. The agreement also
includes a "most favored customer" clause pursuant to which the Company has
agreed to provide price and other terms at least as favorable as those extended
by the Company to other customers for the products covered by the agreement. The
agreement contains certain covenants and conditions relating to product quality
and delivery requirements, among others. Upon a default by the Company with
respect to such covenants and conditions, NYNEX has the right to cancel the
contract, provided such default is not cured within a 14-day notice period.
Either party may terminate the agreement upon default by the other party of any
material provision of the agreement provided such default is not cured within a
10-day notice period. In addition, NYNEX has the right to cancel prior to
shipment any and all orders under the agreement and, in such event, would be
liable to the Company only for the cost of goods not otherwise usable or salable
by the Company. Because NYNEX has the right to terminate orders under the
contract as described above, there can be no assurance that the Company will
ultimately sell the $12 million of products under such contract. However, as of
June 28, 1996, the Company has satisfied the majority of its sales commitment
pursuant to the contract amendment, and is presently competing for another
contract award.
The termination of these or any of the Company's sales agreements would
have a material adverse effect on the Company's business. Further, any
assessment of damages under the Company's sales contracts could have a further
material adverse effect on the Company's operating results and liquidity. In
April 1995, the Company initiated a recall of products as a result of potential
products failures due to contamination introduced into the manufacturing process
by the Company's contract manufacturer. Although the Company's contract
manufacturer was responsible for the repair or replacement of the recalled
product, the Company incurred liquidated damages under the terms of the sales
agreement with its customer in the amount of $200,000. The damages were paid by
an $8.00 price reduction over the next 25,000 units shipped after July 1, 1995.
This liability was recorded in the Company's consolidated financial statements
at March 31, 1995. Also, the Company agreed to extend its warranty on up to
5,000 units shipped under the terms of the sales agreement through December 31,
1998. However, the Company does not anticipate that it will incur significant
warranty costs as a result of the extended warranty.
The Company's prospects and the ability of the Company to maintain a
profitable level of operations are dependent upon its ability to secure contract
awards from the RBOCs. In addition, the Company's prospects for growth are
dependent upon market acceptance and success of its smart products, as well as
development of other smart products containing additional advanced features. If
the Company is unable to attract the interest of the RBOCs to deploy the
Company's smart products, the Company's sales revenues, business and prospects
for growth would be adversely affected. Further, the Company's ability to
maintain and/or increase its sales is dependent upon its ability to compete for
and maintain satisfactory relationships with the RBOCs, particularly those RBOCs
presently representing significant customers of the Company. Prior to a
restructuring instituted in 1994, the Company experienced difficulties with a
first generation smart payphone product, which difficulties subsequently were
remedied. Such difficulties, however, resulted in the termination of a contract
for such product with one of the Company's then significant RBOC customers.
There can be no assurances that similar difficulties will not occur in the
future.
Product Sales Prices
The Company's agreements with its contract manufacturers generally provide
that the Company will bear certain cost increases incurred by the manufacturer.
Accordingly, the Company's manufacturing costs may fluctuate based on costs
incurred by its contract manufacturers and such fluctuations could have a
material and adverse impact on earnings. The Company's sales agreements with
19
customers generally have fixed product prices with limited price escalation
provisions. Consequently, there is a risk that the Company may not be able to
pass on price increases to its customers. In the event the Company's costs
increase or orders are lost due to price increases, the Company's profitability
would be adversely affected. The Company encounters substantial competition with
respect to smart payphone contract awards by the RBOCs. Competition is beginning
to result in price reductions, which will result in reduced gross profit margins
absent reductions in product costs. In connection with the Company's present
efforts to secure another significant smart payphone award from an RBOC, the
Company has lowered its prices in response to competition and sales volume
expectations, and has begun efforts to migrate to lower-cost manufacturing
methods to effect reductions in product costs. In the event the contract is
awarded to the Company, the Company's gross profit percentage will likely
decline until the Company is able to effect planned reductions in product costs.
However, there is no assurance that the contract will be awarded to the Company.
Telecommunications Act of 1996
On February 8, 1996, the President signed into law the Telecommunications
Act of 1996 (the "Telecommunications Act"), the most comprehensive reform of
communications law since the enactment of the Communications Act of 1934. The
Telecommunications Act eliminates long-standing legal barriers separating local
exchange carriers, long distance carriers, and cable television companies and
preempts conflicting state laws in an effort to foster greater competition in
all telecommunications market sectors, improve the quality of services and lower
prices.
The Telecommunications Act expressly supersedes the consent decree which
led to the AT&T Divestiture, including the line-of-business restrictions that
prohibited the RBOCs from providing inter-exchange services and from
manufacturing telecommunications equipment. The RBOCs are now permitted to
provide inter-exchange service outside their local service areas and to seek
approval from the FCC to provide inter-exchange service within their local
service areas based upon a showing that they have opened their local exchange
markets to competition.
The Company believes that as a result of the reform legislation, the public
communications industry will undergo fundamental changes, many of which may
affect the Company's business. The legislation is likely to increase the number
of providers of telecommunications services, including perhaps providers of
payphone services. This increase in the number of providers is likely to
stimulate demand for new payphone equipment. In such event, the Company believes
that existing payphone providers, including the RBOCs, could seek to enhance
their technology base in order to compete more effectively with each other and
with new entrants. In addition, as the local exchange and intrastate long
distance markets are opened to competition, inter-exchange carriers seeking to
serve these markets may deploy greater numbers of payphones to capture local and
intrastate traffic.
In addition, as a result of the Telecommunications Act of 1996, the RBOCs
will be permitted to manufacture and provide telecommunications equipment and to
manufacture customer premises equipment when certain competitive conditions have
been met. It is possible that one or more RBOCs will decide to manufacture
payphone products, which would increase the competition faced by the Company and
could decrease demand for the Company's products by such RBOCs. Notwithstanding,
the Company believes that deregulation generally will benefit the Company.
However, there can be no assurance that the Company will benefit from
deregulation or that it will not be adversely affected by deregulation.
Sources of Supply and Dependence on Contract Manufacturers
The Company generally assembles its smart payphone products from assemblies
produced by certain manufacturers under contractual arrangements. To the extent
that such manufacturers encounter difficulties in their production processes
that delay shipment to the Company or that affect the quality of items supplied
to the Company, the Company's ability to perform its sales agreements or
otherwise to meet supply schedules with its customers can be adversely affected.
In the event that contract manufacturers delay shipments or supply defective
20
materials to the Company, and such delays or defects are material, the Company's
customer relations could deteriorate and its sales and operating results could
be materially and adversely affected.
The majority of the Company's products in terms of revenues contain
components or assemblies that are purchased from single sources. The Company
believes that there are alternative sources of supply for most of the components
and assemblies currently purchased from single sources. Some of the components
and assemblies used by the Company for which there are not immediately available
alternative sources of supply are provided to the Company under standard
purchase arrangements. If a shortage or termination of the supply of any one or
more of such components or assemblies were to occur, however, the Company's
business could be materially and adversely affected. In such event, the Company
would have to incur the costs associated with redesigning its products to
include available components or assemblies or otherwise obtain adequate
substitutes, which costs could be material. Also, any delays with respect to
redesigning products or obtaining substitute components would materially
adversely affect the Company's business.
Litigation and Disputes
In October 1994, a contract manufacturer that delivered allegedly defective
first generation smart products to the Company discontinued operations prior to
the scheduled contract termination date. In April 1995, the contract
manufacturer formally terminated the Company's manufacturing contract as of the
scheduled termination date. Pursuant to the terms of the manufacturing contract,
the Company was committed to acquire the manufacturer's inventories related to
the Company's products. The Company is presently involved in a dispute with the
contract manufacturer with respect to such inventories, which approximate $l
million, unpaid obligations of the Company of approximately $265,000, unpaid
obligations of the contract manufacturer of approximately $125,000 due to the
Company, and other matters including an alleged claim of lost profits by the
contract manufacturer of approximately $916,000 related to the Company's minimum
contract purchase commitment and alleged claims of lost business and expenses of
the Company due to the delivery of defective products and the termination of a
significant smart product sales agreement. The Company is attempting to settle
the dispute with the manufacturer and claims that the manufacturer supplied
defective product and that it breached the agreement by discontinuing operations
prior to the scheduled termination date. However, there is no assurance that the
dispute can be settled in the Company's favor, or at all. Also, there is no
assurance that the dispute will not escalate into litigation. Should the dispute
escalate into litigation, the Company intends to defend and pursue its positions
vigorously. However, there is no assurance that the outcome of the dispute or
potential litigation related thereto will not have a material adverse effect on
the Company's financial position or results of operations.
Net Operating Loss Carryforwards
As of June 28, 1996, the Company had net operating loss carryforwards for
income tax purposes of approximately $15 million to offset future taxable
income. Under Section 382 of the Internal Revenue Code of 1986, as amended, the
utilization of net operating loss carryforwards is limited after an ownership
change, as defined in such Section 382, to an annual amount equal to the value
of the loss corporation's outstanding stock immediately before the date of the
ownership change multiplied by the federal long-term tax-exempt rate in effect
during the month the ownership change occurred. Such an ownership change
occurred on October 31, 1994 and could occur in the future. As a result, the
Company will be subject to an annual limitation on the use of its net operating
losses of approximately $210,000. Such limitation would have the effect of
increasing the Company's tax liability and reducing net income and available
cash resources of the Company if the taxable income during a year exceeded the
allowable loss carried forward to that year. In addition, because of such
limitations, the Company will be unable to use a significant portion of its net
operating loss carryforwards.
21
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings
On July 5, 1994, Multitek Circuitronics, Inc. filed suit against the
Company in United States District Court for the Northern District of Illinois
Eastern Division to collect unpaid obligations of approximately $400,000.
Pursuant to the terms of a settlement agreement and mutual release dated July 3,
1996 this suit was dismissed with prejudice. Pursuant to the terms of the
settlement agreement, the Company paid $180,000 and agreed to pay an additional
$112,500 in six equal monthly installments of $18,750 commencing on August 15,
1996.
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits
The following exhibits are filed herewith as a part of Part I.
Exhibit
No. Description of Exhibit
11. Statement re computation of per share earnings
27. Financial Data Schedule (EDGAR Filing only)
(b) Reports of Form 8-K
There were no reports on Form 8-K filed for the period covered by this
report.
22
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.
TECHNOLOGY SERVICE GROUP, INC.
(Registrant)
Signature Title Date
--------- ----- ----
By: /s/ Vincent C. Bisceglia President & Chief August 6, 1996
--------------------------- Executive Officer, Director
Vincent C. Bisceglia
By: /s/ William H. Thompson Vice President, Finance August 6, 1996
--------------------------- Chief Financial Officer
William H. Thompson Secretary (principal financial
officer)
23
EXHIBIT INDEX
Exhibit No. Description of Exhibit At Page
11. Statement re computation of per share earnings 25
27. Financial Data Schedule (EDGAR filing only) 26
24