FORM 10-QSB - Quarterly
Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
[ X ] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of l934.
For the period ended March 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 0-28462.
----------------
ONLINE SYSTEM SERVICES, INC.
- - - ----------------------------
(Exact name of registrant as specified in its charter)
COLORADO 84-1293864
- - - -----------------------------------------------------------------
(State or other jurisdiction I.R.S. Employer
of incorporation or organization Identification No.)
1800 GLENARM PLACE, SUITE 700, DENVER, CO 80202
- - - -----------------------------------------------------
(Address of principal executive offices) (Zipcode)
(303) 296-9200
- - - --------------
(Registrant's telephone number, including area code)
Not Applicable
- - - --------------
Former name, former address and former fiscal year, if changed since last
report.)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
[ X ] YES [ ] NO
APPLICABLE ONLY TO CORPORATE ISSUERS:
As of May 7, 1998, Registrant had 3,371,407 shares of common stock
outstanding.
ONLINE SYSTEM SERVICES, INC.
Index
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Page
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Part I. Financial Information
Item 1. Unaudited Financial Statements
Balance Sheets as of March 31, 1998 and December 31, 1997 3
Statements of Operations, three months ended March 31, 1998 and 1997 4
Statements of Stockholders' Equity, three months ended March 31, 1998 5
Statements of Cash Flows, three months ended March 31, 1998 and 1997 6
Notes to Financial Statements 7-9
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 10-17
Part II. Other Information
Item 1 and 3-5. Not Applicable 18
Item 6. Exhibits and Reports on Form 8-K 18
Signatures 19
_______________________________
This report contains forward-looking statements within the meaning of Section
21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the
Securities Act of 1933, as amended, and is subject to the safe harbors created
by those sections. These forward-looking statements are subject to significant
risks and uncertainties, including those identified in the section of this Form
10-QSB entitled "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Factors That May Affect Future Operating Results,"
which may cause actual results to differ materially from those discussed in such
forward-looking statements. The forward-looking statements within this Form 10-
QSB are identified by words such as "believes," "anticipates," "expects,"
"intends," "may," "will" and other similar expressions. However, these words
are not the exclusive means of identifying such statements. In addition, any
statements which refer to expectations, projections or other characterizations
of future events or circumstances are forward-looking statements. The Company
undertakes no obligation to publicly release the results of any revisions to
these forward-looking statements which may be made to reflect events or
circumstances occurring subsequent to the filing of this Form 10-QSB with the
Securities and Exchange Commission ("SEC"). Readers are urged to carefully
review and consider the various disclosures made by the Company in this report
and in the Company's other reports filed with the SEC that attempt to advise
interested parties of the risks and factors that may affect the Company's
business.
_______________________________
2
PART I UNAUDITIED FINANCIAL STATEMENTS
ONLINE SYSTEM SERVICES, INC.
BALANCE SHEETS
(UNAUDITED)
MARCH 31, DECEMBER 31,
1998 1997
------------------ ----------------
ASSETS
Current assets:
Cash and cash equivalents $2,154,632 $3,680,282
Accounts receivable, net of allowance for doubtful accounts
of $38,000 and $58,059, respectively 595,106 701,330
Accrued revenue receivables 117,143 143,543
Note receivable (Note 7) 130,967 -
Inventory, net 40,989 235,441
Prepaid expenses 269,760 249,510
Short-term deposits 66,362 77,372
------------------ ----------------
Total current assets 3,374,959 5,087,478
Equipment, net of accumulated depreciation
of $442,356 and 354,371, respectively 1,094,017 1,015,632
Capitalized software costs, net of accumulated amortization
of $9,417 and 2,068, respectively 183,352 122,029
Other assets 101,309 101,352
------------------ ----------------
$4,753,637 $6,326,491
================== ================
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued liabilities $ 539,792 $ 969,937
Accrued salaries and taxes payable 308,905 216,493
Preferred dividend payable 62,399 -
Current portion of capital leases payable 19,022 23,555
Deferred revenue 4,322 9,321
-------------------- -----------------
Total current liabilities 934,440 1,219,306
-------------------- -----------------
Capital leases payable 4,017 585
Stockholders' equity:
Redeemable, convertible preferred stock, 10% cumulative return;
no par value, 5,000,000 shares authorized, 267,500 and 245,000
issued and outstanding, respectively 1,745,079 1,483,282
Common stock; no par value, 10,000,000 shares
authorized, 3,358,282 and 3,315,494 shares
issued and outstanding, respectively 8,778,300 8,635,075
Accumulated deficit (6,708,199) (5,011,757)
Total stockholders' equity 3,815,180 5,106,600
-------------------- -----------------
$ 4,753,637 $ 6,326,491
==================== =================
The accompanying notes to financial statements are an integral part of these
balance sheets.
3
ONLINE SYSTEM SERVICES, INC.
STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended
March 31,
-----------------------------------------
1998 1997
----------------- -----------------
Net sales:
Service sales $ 107,572 $ 402,890
Hardware and software sales 619,667 113,582
----------------- -----------------
727,239 516,472
Cost of sales:
Cost of services 88,519 238,745
Cost of hardware and software 473,034 96,293
----------------- -----------------
561,553 335,038
----------------- -----------------
Gross margin 165,686 181,434
Operating expenses:
New market start-up expenses 141,347 -
Sales and marketing expenses 372,968 285,868
Product development expenses 222,368 209,944
General and administrative expenses 851,474 356,902
Depreciation and amortization 95,377 36,838
----------------- -----------------
1,683,534 889,552
----------------- -----------------
Loss from operations (1,517,848) (708,118)
Interest income, net 29,139 59,654
----------------- -----------------
Net loss (1,488,709) (648,464)
Preferred stock dividends 62,399 -
Accretion of preferred stock to redemption value 145,334 -
----------------- -----------------
Net loss available to common stockholders $(1,696,442) $ (648,464)
================= =================
Loss per share, basic and diluted $(0.51) $(.20)
================= =================
Weighted average shares outstanding 3,335,687 3,172,715
================= =================
The accompanying notes to financial statements are an integral part of these
statements.
4
ONLINE SYSTEM SERVICES, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE THREE MONTHS ENDED MARCH 31, 1998 AND THE YEAR ENDED DECEMBER 31, 1997
(UNAUDITED)
PREFERRED STOCK COMMON STOCK STOCK
-------------------------- ------------------------ SUBSCRIPTIONS ACCUMULATED STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT RECEIVABLE DEFICIT EQUITY
----------- ------------ ---------- ---------- -------------- ----------- -------------
Balances, December 31, 1996 - $ - 3,162,545 $7,953,665 $ (586) $(1,636,478) $ 6,316,601
Preferred stock issued in
conjunction with private
placement 245,000 2,198,875 - - - - 2,198,875
Less offering costs - (280,629) - - - - (280,629)
Common stock issued in
conjunction with private
placement - - 61,250 251,125 - - 251,125
Less offering costs - - - (32,050) - - (32,050)
Guaranteed return on
preferred stock - (434,964) - 434,964 - - -
Exercises of stock options
and warrants - - 91,699 65,611 - - 65,611
Repurchase of option to buy
common stock - - - (75,000) - - (75,000)
Stock options issued for
services - - - 36,760 - - 36,760
Stock subscriptions receivable - - - - 586 - 586
Net loss - - - - - (3,375,279) (3,375,279)
----------- ------------ ---------- ---------- ------------ ----------- -------------
Balances, December 31, 1997 245,000 $ 1,483,282 3,315,494 $8,635,075 $ - $(5,011,757) $ 5,106,600
Preferred stock issued in
conjunction with private
placement (unaudited) 22,500 196,031 - - - - 196,031
Less offering costs
(unaudited) - (23,318) - - - - (23,318)
Common stock issued in
conjunction with private
placement (unaudited) - - 5,625 28,969 - - 28,969
Less offering costs
(unaudited) - - (3,446) - - (3,446)
Guaranteed return on
preferred stock (unaudited) - (56,250) - 56,250 - - -
Exercises of stock options
and warrants (unaudited) - - 37,163 50,410 - - 50,410
Accretion of preferred stock
to redemption (unaudited) - 145,334 - - - - 145,334
Stock options issued for
services (unaudited) - - - 11,042 - - 11,042
Net loss available to common
stockholders for the three
months ended March 31, 1998
(unaudited) - - - - - (1,696,442) (1,696,442)
----------- ------------ ---------- ---------- ------------ ----------- -------------
Balances, March 31, 1998
(unaudited) 267,500 $1,745,079 3,358,282 $8,778,300 $ - $(6,708,199) $ 3,815,180
=========== ============ ========== ========== ============ =========== =============
The accompanying notes to financial statements are an integral part of these
statements.
5
ONLINE SYSTEM SERVICES, INC.
STATEMENT OF CASH FLOWS
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
-----------------------------
1998 1997
------------- ------------
Cash flows from operating activities:
Net loss $(1,488,709) $ (648,464)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization 95,377 36,811
Stock issued for services 11,042 586
Changes in operating assets and liabilities:
Decrease in short-term deposit 11,010 -
(Increase) decrease in accounts receivable 106,224 (170,788)
(Increase) decrease in accrued revenue receivables 26,400 (49,915)
Increase in note receivable (130,967) -
Decrease in inventory 194,452 14,526
Increase in prepaid expenses (20,250) (102,950)
Increase in other assets - (72)
Increase (decrease) in accounts payable and accrued liabilities (430,145) 39,950
Increase in accrued salaries and taxes payable 92,412 -
Decrease in deferred revenue (4,999) (17,800)
------------- ------------
Net cash used in operating activities (1,538,153) (899,116)
------------- ------------
Cash flows from investing activities:
Redemption of short-term investments - 1,153,718
Purchase of equipment (161,270) (55,209)
Capitalized software development costs (68,672) -
------------- ------------
Net cash provided by (used in) investing activities (229,942) 1,098,509
------------- ------------
Cash flows from financing activities:
Payments on capital leases (6,201) (8,555)
Proceeds from issuance of common stock 79,379 11,475
Proceeds from issuance of preferred stock 196,031 -
Stock offering costs (26,764) -
------------- ------------
Net cash provided by financing activities 242,445 2,920
------------- ------------
Net increase (decrease) in cash and cash equivalents (1,526,650) 202,313
Cash and cash equivalents at beginning of period 3,680,282 1,645,163
------------- ------------
Cash and cash equivalents at end of period $ 2,154,632 $1,847,476
============= ============
Supplemental disclosure of cash flow information:
Cash paid for interest $ 1,784 $ 620
Supplemental schedule of non-cash investing and financing activities:
Accretion of preferred stock to redemption value 145,334 -
Preferred stock dividends 62,399 -
Stock issued for services 11,042 586
Capital lease for equipment 5,100
The accompanying notes to financial statements are an integral part of these
statements.
6
ONLINE SYSTEM SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS
MARCH 31, 1998 AND DECEMBER 31, 1997
(UNAUDITIED)
NOTE 1 - BASIS OF PRESENTATION
The accompanying unaudited interim financial statements have been prepared
without audit pursuant to rules and regulations of the Securities and Exchange
Commission and reflect, in the opinion of management, all adjustments, which are
of a normal and recurring nature, necessary for a fair presentation of the
financial position and results of operations for the periods presented. The
preparation of financial statements in accordance with generally accepted
accounting principles requires management to make estimates and assumptions.
Such estimates and assumptions affect the reported amounts of assets and
liabilities as well as disclosure of contingent assets and liabilities at the
date of the accompanying financial statements, and the reported amounts of
revenue and expenses during the reporting period. Actual results could differ
from those estimates. The results of operations for the interim periods are not
necessarily indicative of the results for the entire year.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. Among other factors, the Company has
incurred significant and recurring losses from operations, and such losses are
expected to continue in the near future, which raises substantial doubt about
the ability of the Company to continue as a going concern. Management's plans in
regard to these matters are described in Management's Discussion and Analysis of
Financial Condition and Results of Operations. The accompanying financial
statements do not include any adjustments relating to the recoverability and
classification of asset carrying amounts or the amount and classification of
liabilities that might result should the Company be unable to continue as a
going concern.
NOTE 2 - REVENUE RECOGNITION
Revenue from Web site design and consulting fees is recognized on the
percentage of completion method on an individual contract basis. Percentage
complete is determined primarily based upon the ratio that labor costs incurred
bear to total estimated labor costs. The Company's use of the percentage of
completion method of revenue recognition requires estimates of the degree of
project completion. To the extent these estimates prove to be inaccurate, the
revenues and gross margin, if any, reported for periods during which work on the
project is ongoing, may not accurately reflect the final results of the project,
which can only be determined upon project completion. Provisions for any
estimated losses on uncompleted contracts are made in the period in which such
losses are determinable. Amounts earned but not billed under development
contracts are shown as accrued revenue receivables in the accompanying balance
sheets. Amounts invoiced but not earned are shown as deferred revenue in the
accompanying balance sheets.
Revenue from hardware and software sales is recognized upon shipment
provided that the Company has no significant remaining obligations. Revenue
from maintenance fees, training courses and Internet access fees are recognized
as the services are performed. License fees are recognized when the Company has
no further material obligations.
Revenue from access and content royalties is recognized when earned,
generally as the services are provided.
NOTE 3 - CAPITALIZED SOFTWARE DEVELOPMENT COSTS AND RESEARCH AND DELOPMENT
COSTS
The Company capitalizes software development costs in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 86, "Accounting for the
Costs of Computer Software to be Sold, Leased, or
7
Otherwise Marketed." Capitalization of development costs of software products
begins once the technological feasibility of the product is established. The
establishment of technological feasibility is highly subjective and requires the
exercise of judgment by management. Based on the Company's product development
process, technological feasibility is established upon completion of a detailed
program design. Capitalization ceases when such software is ready for general
release, at which time amortization of the capitalized costs begins.
Amortization of capitalized software development costs is computed using
the greater of the straight-line method or the product's estimated useful life,
generally five years, or based on relative current revenue. During the 1998
period, the Company has used the straight-line method to amortize such
capitalized costs, and recorded $7,349 of amortization expense.
Product development costs relating principally to the design and
development of non-software products and software development costs incurred
prior to technological feasibility are generally expensed as incurred. The cost
of developing routine software enhancements are expensed as product development
costs as incurred because of the short time between the determination of
technological feasibility and the date of general release of related products.
NOTE 4 - CONCENTRATION OF CREDIT RISK
The Company has no significant off balance-sheet concentrations of credit
risk such as foreign exchange contracts, option contracts or other foreign
hedging arrangements. In addition, the Company maintains the majority of its
cash with financial institutions in the form of demand deposits, and denominates
the majority of its transactions in U.S. dollars. At March 31, 1998, the
Company had contracted with an Argentine company to provide ongoing technical
support to one of the Company's customers. The payment for these services is
denominated in Argentine pesos.
The Company performs ongoing evaluations of its customers' financial
condition and generally does not require collateral, except for billings in
advance of work performed. Its accounts receivable balances are primarily
domestic.
NOTE 5 - INCOME TAXES
The Company recognizes deferred income tax assets and liabilities for the
expected future income tax consequences, based on enacted tax laws, of temporary
differences between the financial reporting and tax bases of assets, liabilities
and carryforwards. Deferred tax assets are then reduced, if deemed necessary,
by a valuation allowance for the amount of any tax benefits which, more likely
than not, based on current circumstances, are not expected to be realized
At March 31, 1998, for income tax return purposes, the Company has
approximately $6,800,000 of net operating loss carryforwards that expire at
various dates through the year 2012. The net operating loss for tax purposes
differs from that for financial reporting purposes due to differences in
reporting certain transactions for income tax and financial reporting purposes.
The Tax Reform Act of 1986 contains provisions which may limit the net operating
loss carryforwards available to be used in any given year if certain events
occur, including significant changes in ownership interests.
The Company has determined that deferred tax assets resulting from the net
operating loss carryforwards, as of March 31, 1998 and December 31, 1997,
respectively, did not satisfy the realization criteria. Accordingly, a
valuation allowance was recorded against the entire deferred tax asset. No
other significant deferred tax assets or liabilities existed at March 31, 1998
or December 31, 1997.
The difference between the expected statutory rate and the effective rate
is primarily a result of the increase in the valuation allowance.
8
NOTE 6 - NET LOSS PER SHARE
Net loss per share has been computed based upon the weighted average number
of common shares outstanding.
In February 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 128 (SFAS 128), "Earnings Per
Share." Under SFAS 128, primary earnings per share previously required under
Accounting Principles Board No. 15 is replaced with basic earnings per share.
Basic earnings per share is computed by dividing reported earnings available to
common stockholders by weighted average shares outstanding, excluding the
dilution for any potentially dilutive securities. Fully diluted earnings per
share as defined under Accounting Principles Board No. 15 is called diluted
earnings per share under SFAS 128. Diluted earnings per share reflects the
potential dilution assuming the issuance of common shares for all dilutive
potential common shares outstanding during the period. As a result of the
Company's net losses, all potentially dilutive securities, 1,313,600 stock
options and 1,356,475 warrants for the three months ended March 31, 1998, and
523,990 stock options and 1,298,000 warrants for the three months ended March
31, 1997, would be anti-dilutive. Additionally, at March 31, 1998, the
Company's preferred stock may become convertible into common stock in certain
circumstances.
NOTE 7 PROPOSED BUSINESS COMBINATION
On March 19, 1998, the Company entered into an Agreement and Plan of Merger with
Durand Acquisition Corporation (a wholly owned subsidiary of the Company) and
Durand Communications, Inc. ("DCI"). The Merger Agreement contemplates that the
Company will acquire 100% of the outstanding common stock of DCI and in
consideration therefor (i) will issue up to 971,250 shares of the Company's
common stock to the stockholders of DCI, (ii) reserve approximately 200,000
shares of the Company's common stock for issuance pursuant to exercise or
conversion of options, warrants and convertible securities of DCI to be
converted into similar securities of the Company, and (iii) will assume
approximately $2,300,000 of liabilities of DCI. The Merger Agreement is, among
other things, subject to approval by the shareholders of the Company. DCI, a
privately held company located in Santa Barbara, California, develops and
markets Internet "community" building tools and services, training in the use of
these tools and services and on-line service for hosting these communities.
During the fiscal year ended December 31, 1997, DCI and an acquired business
reported combined revenues of $740,739 and incurred a combined net loss of
($2,867,973). At December 31, 1997, DCI and the acquired company had a combined
accumulated deficit of ($7,709,344).
NOTE 8 NEW ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting
Comprehensive Income." This statement requires that changes in comprehensive
income be shown in a financial statement that is displayed with the same
prominence as other financial statements. The components of comprehensive income
include net income and items that are currently reported directly as a component
of shareholders' equity such as changes in foreign currency translation
adjustments and changes in the fair value of available for sale financial
instruments. The Company has adopted SFAS 130 in the first quarter of 1998.
The adoption has no significant impact on the Company's financial statements.
In June 1997, the FASB issued SFAS No. 131, "Disclosure about Segments of
an Enterprise and Related Information," which changes the manner in which
companies report information about their operating segments. SFAS No. 131,
which is based on the management approach to segment reporting, establishes
requirements to report selected segment information quarterly and to report
entity-wide disclosures about products and services, major customers, and the
geographic locations in which the entity holds assets and reports revenue.
Management is currently evaluating the effects of this change on its reporting
of segment information. The Company will adopt SFAS No. 131 for its fiscal year
ending 1998 and will first be reflected in the Company's 1998 Annual Report on
Form10-KSB.
9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
To date, the Company has generated revenues through the sale of design and
consulting services for Web site development, resale of software licenses, mark-
ups on computer hardware and software sold to customers, maintenance fees
charged to customers to maintain computer hardware and Web sites, license fees
based on a percentage of revenues from the i2u products and services, training
course fees, and monthly fees paid by customers for Internet access provided by
the Company. The Company commenced sales in February 1995, and was in the
development stage through December 31, 1995. The Company has incurred losses
from operations since inception. At March 31, 1998, the Company had an
accumulated deficit of ($6,708,199). The report of the Company's independent
public accountants for the fiscal year ended December 31, 1997, contained a
paragraph noting substantial doubt regarding the Company's ability to continue
as a going concern.
Prior to the quarter ended September 30, 1997, the Company's focus
generally was on three markets: general Web site development, maintenance and
hosting; rural or small market Internet service providers ("ISPs"); and
healthcare information services and continuing medical education ("CME"). These
activities were divided into three separate units early in fiscal 1997; the
Business Resource Group ("BRG") for Web site-related activities; Community
Access America ("CAA") for the ISP activities; and Healthcare for the CME and
healthcare information activities.
Each of these activities involved in varying degrees the establishment of
online communities. As an outgrowth of the Company's BRG and CAA activities,
and in recognition of the need to increase the availability of high-speed
Internet access, the Company's focus during fiscal 1997 increasingly was on the
development of online communities for broadband (high bandwidth or high data
transmission capabilities) operators such as cable TV operators (wired and
wireless) who the Company believes are in the best position today to provide
high-speed Internet access. This focus has resulted in the introduction of the
i2u products and services which include a wide range of online services which
enable operators and operators' customers to generate online local content,
create Web pages and conduct online commerce and banking and a turnkey product
and service package which provides the equipment, training and systems necessary
for the broadband operator to become a fully operational ISP. OSS's revenues
for the i2u products and services include payments for hardware, software
licenses, training and other implementation services as well as a percentage of
Internet access fees paid by subscribers of the Company's broadband operator
customers and in connection with e-commerce and e-banking transactions which
these subscribers conduct on the broadband operator's systems. The Company
intends to focus its future efforts primarily on its i2u products and services.
During November 1997, the Company announced to its customers that it was
terminating Web site development, maintenance and hosting activities and began
to transition this business to other companies. OSS is ceasing Web site
development activities which are not related to the development of products for
its i2u products and services or do not involve the creation of online
communities for particular businesses or information purposes. In addition,
during October 1997, the Company licensed its MD Gateway Web site to Medical
Education Collaborative ("MEC") and is no longer developing products for the
healthcare market. In the future, revenues from the healthcare market are
expected to be limited to license fees received from MEC in connection with the
use of MD Gateway.
Revenues for the businesses that the Company is no longer emphasizing
represented $303,649 of the Company's revenues during the quarter ended March
31, 1997, representing 59% of the total revenues for such period.
The Company intends to increase its capital expenditures and operating
expenses in order to expand its i2u products and services to support additional
broadband operators in future markets and to market and provide the Company's
products and services to a growing number of potential subscribers of the
broadband operators who partner with the Company. As a result, OSS expects to
incur additional substantial operating and net losses in
10
fiscal 1998 and possibly for one or more fiscal years thereafter. There can be
no assurance that such increase will result in increased revenue and/or
customers.
Based on applicable current accounting standards, the Company estimates
that it will be required to record a non-operating expense of approximately
$760,000 during fiscal 1998 in connection with the private placement of
$2,675,000 of the Company's preferred stock which was completed during December,
1997 and March, 1998. While these charges will not affect the Company's
operating loss or working capital, they will result in a decrease in the
Company's net income available to common stockholders during 1998. In addition,
the Company has signed an engagement letter for the private placement of an
additional $3 million of preferred stock which, if completed as contemplated,
would result in an additional non-operating expense during fiscal 1998 (See
Liquidity and Capital Resources, page 13).
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated the percentage of
net sales by items contained in the statements of operations. All percentages
are calculated as a percentage of total net sales, with the exception of cost of
services and cost of hardware/software, which are calculated as a percentage of
service sales and hardware/software sales, respectively.
FOR THE THREE MONTHS ENDED MARCH 31,
---------------------------------------
1998 1997
----------------- ---------------
Net Sales:
Service sales 14.8% 78.0%
Hardware/software sales 85.2% 22.0%
----------------- ---------------
Total net sales 100.0% 100.0%
Cost of sales:
Cost of services
(as percentage of service sales) 82.3% 59.3%
Cost of hardware/software
(as percentage of hardware/software sales) 76.3% 84.8%
----------------- ---------------
Total cost of sales 77.2% 64.9%
Gross margin 22.8% 35.1%
----------------- ---------------
Operating expenses:
New market start-up expenses 19.4% -
Sales and marketing expenses 51.3% 55.4%
Product development expenses 30.6% 40.6%
General and administrative expenses 117.1% 69.1%
Depreciation and amortization expenses 13.1% 7.1%
----------------- ---------------
Total operating expenses 231.5% 172.2%
Loss from operations (208.7%) (137.1%)
Net loss (204.7%) (125.6%)
Preferred stock dividends (8.6%) -
Accretion of preferred stock to redemption value (20.0%) -
Net loss available to common stockholders (233.3%) (125.6%)
11
Three Months Ended March 31, 1998 and 1997
Net sales for the three months ended March 31, 1998 totaled $727,239,
including $107,572 for service sales and $619,667 for hardware and software
sales. This represents an increase of 41% above 1997 net sales of $516,472,
which consisted of $402,890 for service sales and $113,582 for hardware and
software sales. For the three months ended March 31, 1998, the Company had
three customers representing 80% of sales. One customer represented 12% of net
sales for the same period in 1997. The increase in sales for the 1998 period
compared to 1997, was due to the expanded development of the Company's i2u
product and service offerings, and to a substantial increase in marketing and
sales efforts in the broadband market. Initial revenues from sales of i2u
products and services include a higher percentage of hardware sales due to the
need for the Company's broadband operators to acquire the equipment necessary to
become an Internet service provider at the beginning of the transaction.
Service fees decreased in the 1998 period due to the discontinuance in the
fourth quarter of 1997 of web site development, maintenance and hosting
activities.
Cost of sales as a percentage of net sales was 77.2% for the 1998 period and
64.9% for the comparable 1997 period. Cost of sales on hardware and software
sales are generally higher than on service sales. Therefore, the Company's
overall gross profit margin is higher during periods when service sales are a
greater percentage of total net sales. Sales of hardware and software as a
percent of total sales increased significantly over the 1997 period, which
contributed to the higher overall cost of sales. The higher cost of sales on
hardware and software for the 1998 period was due to equipment sales to larger
customers, which were at lower margins.
New market start-up costs consists of expenditures associated with
developing markets for the Company's i2u products in association with its
broadband operators. For the three months ended March 31, 1998, new market
start-up costs were $141,347, or 19.4% of net sales.
Sales and marketing expenses were $372,968 for the three months ended March
31, 1998 and $285,868 for the 1997 period. Sales and marketing expenses as a
percentage of net sales decreased slightly from 55.4% in 1997 to 51.3% in 1998.
The increase in dollars spent during the 1998 three-month period was due to the
hiring of new sales and marketing personnel and associated expenditures. During
the 1998 quarter, the Company also developed initial marketing materials, began
lead generation activity and began to sell its i2u products and services.
Product development expenses were $222,368 for the three months ended March
31, 1998, compared to $209,944 for the 1997 period. Product development expense
as a percentage of net sales decreased from 40.6% in 1997 to 30.6% in 1998. The
Company capitalized $68,672 of development costs during the 1998 period related
to the continued development of its i2u product. Product development expenses
during the 1998 period included the completion of the initial development of the
Company's i2u product and addition of wireless cable capabilities. Product
development expenses are expected to continue to increase during 1998 as the
Company continues to develop the i2u, e-banking and e-commerce products and
services.
General and administrative expenses were $851,474 for the three months ended
March 31, 1998, compared to $356,902 for the 1997 period. General and
administrative expenses as a percentage of net sales increased from 69.1% in
1997 to 117.1% in 1998. The dollar and percentage increases reflect the
development of the Company's general and administrative infrastructure,
including finance, accounting and business development capabilities. In
addition, during the latter part of the three-month period ended March 31, 1998,
the Company incurred expenses and developed capabilities to enter into the
international market for its i2u products and services.
Depreciation and amortization expenses were $95,377 for the three months
ended March 31, 1998, compared to $36,838 for the 1997 period. This increase
reflects the increase in fixed assets and equipment to support higher levels of
Web site and Internet access services, i2u development and testing, as well as
to support the growth in the number of employees.
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Interest income was $29,139 during the three-month period ended March 31,
1998, compared to $59,654 for the 1997 period. The dollar decrease is due to
utilization of the Company's cash reserves to fund its expanding operations. The
Company's investments consist of corporate commercial paper and cash
equivalents.
Net losses available to common stockholders were $(1,696,442) for the three-
month period ended March 31, 1998 compared to $(648,464) for the 1997 period.
The increase in losses in the 1998 period reflect non-operating expenses of
$62,399 of preferred stock dividends and $145,334 of accretion of preferred
stock to redemption value. Additionally, the increase in losses reflect
expenses in the marketing and sales, product development, and general and
administrative areas that have increased at a faster rate than net sales. This
is due to the time lag associated with product development and market
introduction as well as the long sales cycle for most of the Company's products
and services. The Company expects to continue to experience increased operating
expenses and capital investments during fiscal 1998, as it continues to develop
new product offerings and the infrastructure required to support its anticipated
growth. The Company believes that, initially, these expenses will be greater
than increases in net sales. The Company expects to report operating and net
losses for fiscal 1998 and for one or more fiscal years thereafter.
LIQUIDITY AND CAPITAL RESOURCES
As of March 31, 1998, the Company had cash and cash equivalents of
$2,154,632 and working capital of $2,440,519. The Company has financed its
operations and capital equipment expenditures through a combination of public
and private sales of common stock, issuing common stock for services, lease
financing, short-term loans and the utilization of trade payables. During the
three months ended March 31, 1998, the Company completed a private placement
which resulted in net proceeds to the Company of $198,236 and the issuance of
22,500 shares of 10% cumulative convertible redeemable preferred stock, 5,625
shares of common stock and 4,500 common stock purchase warrants.
During the three months ended March 31, 1998, the Company purchased $161,270
of fixed assets. These purchases were primarily computer equipment,
communications equipment, cable modems and software necessary to develop and
demonstrate the recently introduced i2u products. In anticipation of future
growth, the Company expects to invest a minimum of $500,000 during fiscal 1998
to purchase additional computer equipment, software and office equipment.
Accounts receivable balances decreased from $701,330 at December 31, 1997 to
$595,106 at March 31, 1998, due to the collection of receivables from sales
recorded in the fourth quarter of 1997. Due to the Company's utilization of the
percentage of completion method of revenue recognition for its Web services, an
asset of $117,143 representing revenue earned and not billed is shown as accrued
revenue receivables at March 31, 1998. This amount has decreased from $143,543
at December 31, 1997, as a result of billing for the completion of web
development projects in the first quarter of 1998. A liability for amounts
invoiced but not earned of $4,322 is shown as deferred revenue at March 31,
1998. The Company's hardware and software inventory of $40,989 at March 31,
1998 decreased from $235,441 at December 31, 1997, and consists of software
licenses and computer hardware purchased by the Company for resale.
Prepaid expenses increased to $269,760 at March 31, 1998, from $249,510 at
December 31, 1997, primarily due to amounts paid for costs incurred related to
the proposed merger with DCI. The major portion of the remaining balance
consists of a software license and inventory purchased at a discount which is
anticipated to be consumed in 1998. Trade accounts payable and accrued
liabilities at March 31, 1998, decreased to $539,792 from $969,937 at December
31, 1997, primarily due to a reduction in payables for equipment purchased to
support inventory requirements for sales at the end of the December 31, 1997
period and sales that were anticipated for the early part of the March 31, 1998
period.
The Company believes that its cash and cash equivalents and working capital
at March 31, 1998, plus the net proceeds of the offering of preferred stock that
was completed during March 1998 will be adequate to sustain operations through
May 1998. The Company has entered into an agreement for the sale of additional
preferred stock which, if successfully completed, will result in net proceeds to
the Company of approximately $2,700,000. In
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addition, the Company has entered into a letter of intent with an underwriter
for a secondary offering of its securities for proceeds of $15 to $20 million,
which is expected to occur during the third quarter of 1998. The Company
estimates that it needs to raise at least $15 million through equity, debt or
other external financing, to implement its business development plan. However,
there can be no assurances that the Company will be able to complete such
offerings in amounts required by the Company or upon terms acceptable to the
Company. There is no assurance that any additional capital resources, which the
Company may need, will be available when required, or, if available, available
on terms acceptable to the Company.
If financing can not be arranged, the Company would consider scaling back
operations, seeking strategic alliances, or other similar actions to allow the
Company to continue operating.
YEAR 2000
The Company utilizes software and related technologies throughout its
business and relies on suppliers of services and materials that will be affected
by the date change in the year 2000 or prior. The Year 2000 issue exists
because many computer systems and applications currently use two-digit fields to
designate a year. As the century date change occurs, date-sensitive systems may
recognize the year 2000 as 1900, or not at all. This inability to recognize or
properly treat the Year 2000 may cause systems to process critical financial and
operational information incorrectly. The Company believes that all computer
hardware and software used, developed, or sold by the Company is Year 2000
compliant. An internal study is currently under way to determine the full scope
and related costs, if any, to insure that the Company's vendors' systems
continue to meet its internal needs and those of its customers. The Company
does not anticipate incurring significant expenses related to this issue.
FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
Limited Operating History; Accumulated Losses. The Company was founded in
March 1994, commenced sales in February 1995 and was in the development stage
through December 31, 1995. Accordingly, the Company has only a limited
operating history upon which an evaluation of the Company and its prospects can
be based. The Company's prospects must be considered in light of the risks,
expenses and difficulties frequently encountered by companies in their early
stage of development, particularly companies in new and rapidly evolving
markets. To address these risks, the Company must, among other things, respond
to competitive developments, continue to attract, retain and motivate qualified
persons, and continue to upgrade and commercialize products and services. There
can be no assurance that the Company will be successful in addressing such
risks. The Company has incurred net losses since inception. As of March 31,
1998, the Company had an accumulated deficit of ($6,708,199). This accumulated
deficit does not include losses of $266,193 that were incurred by the Company
from inception through September 26, 1995 because the Company was a Subchapter S
corporation during that period.
Additional Anticipated Losses. OSS currently intends to increase its
capital expenditures and operating expenses in order to expand its i2u products
and services and to support additional subscribers of OSS' broadband customers
in future markets and to market and provide the Company's products and services
to a growing number of potential subscribers. As a result, the Company expects
to incur additional substantial operating and net losses for the balance of
fiscal 1998 and for one or more fiscal years thereafter. The profit potential
for the Company's i2u business model is unproven, and to be successful, the
Company must, among other things, develop and market products and services that
are widely accepted by consumers and businesses at prices that will create a
profit. The Company's i2u products and services have only recently been
launched and there can be no assurance that they will achieve broad consumer or
commercial acceptance. The success of the Company's i2u products and services
will depend upon the willingness of subscribers of the Company's broadband
customers to pay monthly fees and installation costs of the Internet service,
both of which will be set by local broadband operators. In addition, since a
significant portion of the Company's future sales are expected to be transaction
based, the success of the Company's i2u products and services may also be
dependent upon the extent to which consumers and businesses conduct e-commerce
and e-banking. Accordingly, it is difficult to predict whether OSS' pricing
model will prove to be viable, whether demand for the Company's products and
services will materialize at the prices the Company
14
expects the broadband operators to charge or whether current or future pricing
levels will be sustainable. If such pricing levels are not achieved or sustained
or if the Company's products and services do not achieve or sustain broad market
acceptance, the Company's business, operating results and financial condition
will be materially adversely affected. OSS' ability to generate future sales
will be dependent on a number of factors, many of which are beyond the Company's
control, including, among others, the success of broadband operators in
marketing Internet services to subscribers in their local areas, the extent that
subscribers conduct online e-commerce and e-banking transactions and the prices
that the broadband operators set for Internet services. Because of the foregoing
factors, among others, OSS is unable to forecast its sales with any degree of
accuracy. There can also be no assurance that the Company will ever achieve
profitability.
New and Uncertain Markets. The market for Internet products and services
has only recently developed. Since this market is relatively new and because
current and future competitors are likely to introduce competing Internet
products and services, it is difficult to predict the rate at which the market
will grow or at which new or increased competition will result in market
saturation. If the Internet markets fail to grow, grow more slowly than
anticipated or become saturated with competitors, the Company's business,
operating results and financial condition will be materially adversely affected.
Product Development; Technological Change. The Company's success depends
upon its ability to develop new products and services that meet changing
customer requirements. The market for the Company's products and services is
characterized by rapidly changing technology, evolving industry standards,
emerging competition and frequent new product and service introductions. There
can be no assurance that the Company can successfully identify new product and
service opportunities or develop and bring new products and services to market
in a timely manner, or that products and services or technologies developed by
others will not render the Company's products and services or technologies
noncompetitive or obsolete.
General Risks of Business. The Company has formulated its business plans
and strategies based on the rapidly increasing size of the Internet markets, the
Company's anticipated participation in those markets, and the estimated sales
cycle, price and acceptance of the Company's products and services. Although
these assumptions are based on the best estimates of management, there can be no
assurance that these assumptions will prove to be correct. No independent
marketing studies have been conducted on behalf of or otherwise obtained by the
Company, nor are any such studies planned. Any future success that the Company
might enjoy will depend upon many factors including some beyond the control of
the Company or that it cannot predict at this time.
Intense Competition. The market for Internet products and services is
highly competitive and the Company expects that this competition will intensify
in the future. The Company's current and prospective competitors include many
companies that have substantially greater financial, technical, marketing and
other resources than the Company. Increased competition could result in price
reductions and increased spending on marketing, sales and product development.
Any of these events could have a materially adverse effect on the Company's
financial condition and operating results. Many nationally known companies and
regional and local companies across the country are involved in Internet
applications and the number of competitors is growing. The Company will also
compete with broadband companies who are developing their own Internet access
and content and the internal departments of prospective customers who are
choosing whether to outsource Internet-related activities or retain or develop
that function in-house. Customers who desire to outsource these services may
desire to work with companies larger than OSS. Increased competition could
result in significant price competition, which in turn could result in
significant reductions in the average selling price of the Company's products
and services. There is no assurance that the Company will be able to offset the
effects of any such price reductions through an increase in the number of its
customers, higher sales from enhanced services, cost reductions or otherwise.
Increased competition or price reductions could adversely affect the Company's
operating results. There is no assurance that the Company will have the
financial resources, technical expertise or marketing, sales and support
capabilities to continue to compete successfully.
Limited Availability of Proprietary Protection. The Company does not
believe that its current products or services are patentable. The Company
relies on a combination of copyright, trade secret and trademark laws, and
nondisclosure and other contractual provisions to protect its proprietary
rights. Notwithstanding these safeguards,
15
it may be possible for competitors of the Company to imitate the Company's
products and services or to develop independently competing products and
services. See "Business-Trademarks and Proprietary Protection."
Length of Sales Cycle. The decision to enter the Internet services
provisioning business and the development and implementation of interactive Web
sites are often enterprise-wide decisions by prospective customers and may
require the Company to engage in lengthy sales cycles. The pursuit of sales
leads typically involves an analysis of the prospective customer's needs,
preparation of a written proposal, and one or more presentations and contract
negotiations. The Company often provides significant education to prospective
customers regarding the use and benefits of Internet technologies and products.
While the sales cycle varies from customer to customer, it typically has ranged
from one to three months for i2u projects. The sales cycle may also be subject
to a prospective customer's budgetary constraints and internal acceptance
reviews, over which the Company has little or no control. Consequently, if
sales forecasted from a specific customer for a particular quarter are not
realized in that quarter, the Company is unlikely to be able to generate revenue
from alternate sources in time to compensate for the shortfall. If a larger
order is delayed or lost to a competitor, the Company's revenues for that
quarter could be materially diminished. Moreover, to the extent that
significant sales occur earlier than expected, operating results for subsequent
quarters may be adversely affected. A significant portion of the Company's
future sales are expected to come from Internet access fees paid by subscribers
of the Company's broadband operator customers and in connection with e-commerce
and e-banking transactions these subscribers conduct on the broadband operators'
systems. OSS expects that it may take broadband operators several months or
more to market and sell high-speed Internet access to their subscribers and that
it will take even longer for these subscribers to conduct significant e-commerce
or e-banking transactions. For these reasons, OSS does not expect to realize
significant sales, if at all, from these activities until a significant time
after OSS has licensed its i2u products and services to broadband operators.
Dependence on Key Personnel; Absence of Employment and Noncompetition
Agreements. The Company is highly dependent on the technical and management
skills of its key employees, including in particular R. Steven Adams, the
Company's founder, President and Chief Executive Officer. The loss of Mr.
Adams' services could have a material adverse effect on the Company's business
and operating results. The Company has not entered into employment agreements
with Mr. Adams, or any of its other officers or employees and has not purchased
key person insurance for Mr. Adams or any other member of management. The
Company generally enters into written nondisclosure and nonsolicitation
agreements with its officers and employees which restrict the use and disclosure
of proprietary information and the solicitation of customers for the purpose of
selling competing products or services. Thus, if any of the Company's officers
or key employees left the Company, they could compete with the Company, so long
as they did not solicit the Company's customers, which could have a material
adverse effect on the Company's business. The Company's future success also
depends in part on its ability to identify, hire and retain additional
personnel, including key product development, sales, marketing, financial and
executive personnel. Competition for such personnel is intense and there is no
assurance that the Company can identify or hire additional qualified personnel.
Management of Growth. The Company has and expects to continue to experience
significant growth in the number of its employees, the scope of its operating
and financial systems, and the geographic area of its operations, including an
expansion of its recently initiated international operations. This growth will
result in new and increased responsibilities for both existing and new
management personnel. In addition, as the Company expands its i2u products and
services, it will be necessary to hire additional employees who will be located
at many widely separated offices, including international offices. The
Company's success depends on the ability of its managers to operate effectively,
both independently and as a group. The Company's ability to effectively manage
any such growth will require it to continue to implement and improve its
operational, financial and management information systems and to train, motivate
and manage its employees. This will require the addition of new management
personnel and the development of additional expertise by existing management.
There can be no assurance that the Company's management or other resources will
be sufficient to manage any future growth in the Company's business or that the
Company will be able to implement in whole or in part its growth strategy, and
any failure to do so could have a material adverse effect on the Company's
operating results.
16
Potential Fluctuations in Quarterly Results. As a result of the Company's
limited operating history and the recent increased focus on its i2u products and
services, the Company does not have historical financial data for a sufficient
number of periods on which to base planned operating expenses. Accordingly, the
Company's expense levels are based in part on its expectations as to future
sales and to a large extent are fixed. The Company typically operates with
little backlog and the sales cycles for its products and services may vary
significantly. As a result, quarterly sales and operating results generally
depend on the volume and timing of and ability to close customer contracts
within the quarter, which are difficult to forecast. The Company may be unable
to adjust spending in a timely manner to compensate for any unexpected sales
shortfalls. Accordingly, any significant shortfall of demand for the Company's
products and services in relation to the Company's expectations would have an
immediate adverse effect on the Company's business, operating results and
financial condition. In addition, since a significant portion of the Company's
future sales are expected to be based on Internet access fees and e-commerce and
e-banking activities, OSS does not expect to realize significant sales, if at
all, from these activities until a significant time after OSS has licensed its
i2u products and services to broadband operators. Further, the Company plans to
increase its operating expenses to fund product development and increase sales
and marketing. To the extent that such expenses precede or are not subsequently
followed by increased sales, the Company's business, operating results and
financial condition will be materially adversely affected.
Security Risks. The Company's software and equipment are vulnerable to
computer viruses or similar disruptive problems caused by OSS customers or other
Internet users. Computer viruses or problems caused by third parties could lead
to interruptions, delays or cessation in service to the Company's customers.
Furthermore, inappropriate use of the Internet by third parties could also
potentially jeopardize the security of confidential information stored in the
computer systems of the Company's customers. The Company has information
technology insurance which provides limited coverage for losses caused by
computer viruses. However, certain losses resulting from misuse of software or
equipment by third parties or losses from computer viruses which exceed the
liability limits under such insurance may not be protected. Although the
Company attempts to limit its liability to customers for these types of risks
through contractual provisions, there is no assurance that these limitations
will be enforceable.
Dependence on the Internet. Sales of the Company's Internet related
products and services will depend in large part upon a robust industry and
infrastructure for providing Internet access and carrying Internet traffic. The
Internet may not prove to be a viable commercial marketplace because of
inadequate development of the necessary infrastructure, such as a reliable
network backbone or timely development of complementary products. Because
global commerce and online exchange of information on the Internet and other
similar open wide area networks are new and evolving, it is difficult to predict
with any assurance whether the Internet will prove to be a viable commercial
marketplace. There can be no assurance that the infrastructure or complementary
products necessary to make the Internet a viable commercial marketplace will be
developed, or, if developed, that the Internet will become a viable commercial
marketplace. If the necessary infrastructure or complementary products are not
developed, or if the Internet does not become a viable commercial marketplace,
the Company's business, operating results and financial condition will be
materially impaired.
17
PART II
OTHER INFORMATION
Items 1 and 3-5. Not Applicable
Item 2. Changes in Securities and Use of Proceeds
On March 12, 1998, the Company completed the sale of 2.25 units ("Units") of
its securities to a total of 4 private investors for an aggregate consideration
of $225,000 ($100,000 per Unit). An additional 24.5 Units ($2,450,000) were
sold to 18 private investors during December 1997. Each unit consisted of
10,000 shares of the Company's 10% Cumulative Convertible Redeemable Preferred
Stock, 2,500 shares of its Common Stock, and 2,000 Common Stock Purchase
Warrants. Each Warrant entitles the holder thereof to purchase one share of
Common Stock of the Company for the purchase price of $15.00 per share at any
time during the three-year period ending on December 31, 2000. Cohig &
Associates, Inc. served as the placement agent for the offering and received a
commission equal to 8% of the gross proceeds of the offering and a non-
accountable expense allowance of 2% of the gross proceeds. The Preferred Stock
may be redeemed by the Company at any time for $10.00 per share. If the
Preferred Stock is not redeemed prior to October 1, 1998, the Preferred Stock
shall become convertible at the election of the holder thereof, into a number of
shares of Common Stock of the Company equal to $10.00 divided by the lessor of
$10.00 or 80% of the average per share closing bid price of the Company's Common
Stock for the five trading days preceding the date of conversion (as defined).
The Securities were not registered under the Securities Act of 1933, as amended,
based upon the exemption provided in Section 4(2) of such act and Regulation D
promulgated thereunder. The securities were "restricted" securities as defined
in Rule 144 promulgated by the Securities and Exchange Commission and were
acquired for investment purposes. The certificates representing such securities
contained restrictive legends. The securities are subject to a demand
registration right granting the holders thereof the right to request that one
registration statement covering certain of the securities be filed with the
Securities and Exchange Commission, provided that the Company is not obligated
to file the registration statement prior to September 30, 1998.
ITEM 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 27 - Financial Data Schedule
(b) Reports on Form 8-K
None
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SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
ONLINE SYSTEM SERVICES, INC.
Date: May 15, 1997 By /S/ Thomas S. Plunkett
----------------------
Vice President and
Chief Financial Officer
/S/ Stuart J. Lucko
-------------------
Controller
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