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 quarterly period ended June 30, 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.
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ONLINE SYSTEM SERVICES, INC.
- ----------------------------
(Exact name of registrant as specified in its charter)
COLORADO 84-1293864
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(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
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(Registrant's telephone number, including area code)
Not Applicable
- --------------
(Former name, former address and former fiscal year, if changed since last
report.)
Check whether the issuer: (1) filed all reports required to be filed by Section
13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or
for such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.
[X] YES [_] NO
APPLICABLE ONLY TO CORPORATE ISSUERS:
As of August 5, 1998, Registrant had 3,515,581 shares of common stock
outstanding.
ONLINE SYSTEM SERVICES, INC.
INDEX
Page
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Part I. Financial Information
Item 1. Unaudited Financial Statements
Balance Sheets as of June 30, 1998 and December 31, 1997 3
Statements of Operations for the three and six months ended June 30, 1998 and 1997 4
Statements of Stockholders' Equity for the six months ended June 30, 1998 5
Statements of Cash Flows for the six months ended June 30, 1998 and 1997 6
Notes to Financial Statements 7-11
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12-19
Part II. Other Information
Item 1, 3
and 5. Not Applicable 20
Item 2. Changes in Securities and Use of Proceeds 20
Item 4. Submission of Matters to a Vote of Security Holders 20
Item 6. Exhibits and Reports on Form 8-K 21
Signatures 22
--------------------------
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 FINANCIAL INFORMATION
ITEM 1 FINANCIAL STATEMENTS
ONLINE SYSTEM SERVICES, INC.
BALANCE SHEETS
(UNAUDITED)
June 30, December 31,
1998 1997
------------------ ----------------
ASSETS
Current assets:
Cash and cash equivalents $ 2,769,625 $ 3,680,282
Accounts receivable, net of allowance for doubtful accounts
of $40,889 and $58,059, respectively 577,901 701,330
Accrued revenue receivables 63,265 143,543
Note receivable 585,441 -
Inventory, net 62,603 235,441
Prepaid expenses 185,954 249,510
Deferred assets 124,636 -
Short-term deposits 63,292 77,372
------------------ ----------------
Total current assets 4,432,717 5,087,478
Equipment, net of accumulated depreciation
of $537,263 and $354,371, respectively 1,081,252 1,015,632
Capitalized software costs, net of accumulated amortization
of $20,439 and $2,068, respectively 299,949 122,029
Other assets 101,267 101,352
------------------ ----------------
$ 5,915,185 $ 6,326,491
================== ================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued liabilities $ 587,019 $ 969,937
Accrued salaries and taxes payable 228,643 216,493
Preferred dividend payable 142,984 -
Current portion of capital leases payable 18,585 23,555
Deferred revenue - 9,321
------------------ ----------------
Total current liabilities 977,231 1,219,306
Capital leases payable 9,172 585
Stockholders' equity:
Preferred stock, no par value, 5,000,000 shares authorized:
Redeemable, convertible preferred stock, 10% cumulative return;
267,500 and 245,000 issued and outstanding, respectively 2,287,794 1,483,282
Redeemable, convertible preferred stock, 5% cumulative return;
3,000 and none issued and outstanding, respectively 2,115,528 -
Common stock; no par value, 10,000,000 shares authorized,
3,497,849 and 3,315,494 shares issued and outstanding, respectively 9,801,362 8,635,075
Accumulated deficit (9,275,902) (5,011,757)
------------------ -----------------
Total stockholders' equity 4,928,782 5,106,600
------------------ -----------------
$ 5,915,185 $ 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 Six months ended
June 30, June 30,
--------------------------- ---------------------------
1998 1997 1998 1997
----------- ----------- ----------- -----------
Net sales:
Service sales $ 90,820 $ 473,316 $ 198,392 $ 876,206
Hardware and software sales 209,988 175,381 829,655 288,963
----------- ----------- ----------- -----------
300,808 648,697 1,028,047 1,165,169
Cost of sales:
Cost of services 58,919 296,830 147,438 535,575
Cost of hardware and software 207,901 147,763 680,935 244,056
----------- ----------- ----------- -----------
266,820 444,593 828,373 779,631
----------- ----------- ----------- -----------
Gross margin 33,988 204,104 199,674 385,538
Operating expenses:
New market start-up expenses 204,922 - 346,269 -
Sales and marketing expenses 406,529 245,404 779,498 531,272
Product development expenses 131,202 229,557 353,570 439,501
General and administrative expenses 857,062 384,844 1,708,585 741,746
Depreciation and amortization 105,970 38,500 201,347 75,338
----------- ----------- ----------- -----------
1,705,685 898,305 3,389,269 1,787,857
----------- ----------- ----------- -----------
Loss from operations (1,671,697) (694,201) (3,189,595) (1,402,319)
Interest income, net 33,225 49,969 62,414 109,623
----------- ----------- ----------- -----------
Net loss (1,638,472) (644,232) (3,127,181) (1,292,696)
Preferred stock dividends 80,585 - 142,984 -
Accretion of preferred stock to redemption value 848,646 - 993,980 -
----------- ----------- ----------- -----------
Net loss available to common stockholders $(2,567,703) $ (644,232) $(4,264,145) $(1,292,696)
=========== =========== =========== ===========
Loss per share, basic and diluted $ (0.75) $ (0.20) $ (1.26) $ (0.41)
=========== =========== =========== ===========
Weighted average shares outstanding 3,446,131 3,185,276 3,390,909 3,179,030
=========== =========== =========== ===========
The accompanying notes to financial statements are an integral part of these
statements.
4
ONLINE SYSTEM SERVICES, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND THE YEAR ENDED DECEMBER 31, 1997
(UNAUDITED)
5% Preferred Stock 10% Preferred Stock Common Stock Stock
------------------ ------------------- --------------------- Subscriptions Accumulated Stockholders'
Shares Amount Shares Amount Shares Amount Receivable Deficit Equity
------ --------- -------- --------- --------- ---------- ------------- ----------- ------------
Balances, December 31,
1996 - $ - - $ - 3,162,545 $7,953,665 $ (586) $(1,636,478) $6,316,601
Stock issued in
conjunction with
private placement-
10% Preferred stock
issued - - 245,000 2,198,875 - - - - 2,198,875
Common stock issued - - - - 61,250 251,125 - - 251,125
Less offering costs - - - (280,629) - (32,050) - - (312,679)
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
Stock issued in conjunction
with private placement-
5% Preferred stock
(unaudited) 3,000 2,806,000 - - - - - - 2,806,000
Common stock warrants
(unaudited) - - - - 50,000 194,000 - - 194,000
Less offering costs
(unaudited) - (481,930) - - - (33,320) - - (515,250)
Warrants issued for
placement fee
(unaudited) - - - - - 194,000 - - 194,000
Guaranteed return on 5%
preferred stock
(unaudited) - (514,473) - - - 514,473 - - -
Stock issued in conjunction
with private placement-
10% Preferred stock
(unaudited) - - 22,500 196,031 - - - - 196,031
Common stock (unaudited) - - - - 5,625 28,969 - 28,969
Less offering costs
(unaudited) - - - (23,318) - (3,446) - - (26,764)
Guaranteed return on 10%
preferred stock
(unaudited) - - - (56,250) - 56,250 - - -
Exercises of stock options
and warrants (unaudited) - - - - 126,730 189,182 - - 189,182
Accretion of preferred stock
to redemption (unaudited) - 305,931 - 688,049 - - - - 993,980
Stock options issued for
services (unaudited) - - - - - 26,179 - - 26,179
Net loss available to common
stockholders for the six
months ended June 30, 1998
(unaudited) - - - - - - - (4,264,145) (4,264,145)
------ ---------- -------- ---------- --------- ----------- ------------ ----------- -----------
Balances, June 30, 1998
(unaudited) 3,000 $2,115,528 267,500 $2,287,794 3,497,849 $9,801,362 $ - $(9,275,902) $ 4,928,782
====== ========== ======== ========== ========= =========== ============ =========== ===========
The accompanying notes to financial statements are an integral part of these
statements.
5
ONLINE SYSTEM SERVICES, INC.
STATEMENT OF CASH FLOWS
(UNAUDITED)
Six months ended
June 30,
------------------------------
1998 1997
------------- -------------
Cash flows from operating activities:
Net loss $(3,127,181) $(1,292,696)
Adjustments to reconcile net loss to net cash used in operating activities:
Operating activities:
Depreciation and amortization 201,347 75,338
Accrued interest income on advances to DCI (10,441) -
Stock issued for services 26,179 586
Changes in operating assets and liabilities:
(Increase) decrease in accounts receivable 123,429 (251,457)
(Increase) decrease in accrued revenue receivables 80,278 (120,875)
Decrease in inventory 172,838 70,319
(Increase) decrease in prepaid expenses 63,557 (172,819)
Decrease in short-term deposits 14,080 -
Increase in other assets - (55)
Increase (decrease) in accounts payable and accrued liabilities (382,918) 132,659
Increase in accrued salaries and taxes payable 12,150 93,289
Increase (decrease) in deferred revenue (9,321) 37,207
------------- -------------
Net cash used in operating activities (2,836,003) (1,428,503)
------------- -------------
Cash flows from investing activities:
Proceeds from short-term investments - 3,855,343
Purchase of equipment (229,762) (271,964)
Capitalized software development costs (196,291) -
Cash advances to DCI (575,000) -
Payment of deferred assets (124,636) -
------------- -------------
Net cash provided by (used in) investing activities (1,125,689) 3,583,379
------------- -------------
Cash flows from financing activities:
Payments on capital leases and notes payable (15,133) (90,547)
Proceeds from issuance of common stock warrants 194,000 -
Proceeds from issuance of common stock 218,151 18,183
Proceeds from issuance of 10% preferred stock and warrants 196,031 -
Proceeds from issuance of 5% preferred stock 3,000,000 -
Stock offering costs (348,014) -
------------- -------------
Net cash provided by (used in) financing activities 3,051,035 (72,364)
------------- -------------
Net increase (decrease) in cash and cash equivalents (910,657) 2,082,512
Cash and cash equivalents at beginning of period 3,680,282 1,645,163
------------- -------------
Cash and cash equivalents at end of period $ 2,769,625 $ 3,727,675
============= =============
The accompanying notes to financial statements are an integral part of these
statements.
6
ONLINE SYSTEM SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS
JUNE 30, 1998 AND DECEMBER 31, 1997
(UNAUDITED)
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.
During 1998, the Company changed its business model to become more reliant
on royalty revenue from the use of its products and services. In general, the
Company will be paid a royalty when the subscriber of a customer of the
Company's i2u software and hardware product accesses such products.
NOTE 3 - CAPITALIZED SOFTWARE DEVELOPMENT COSTS AND RESEARCH AND DEVELOPMENT
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 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
7
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. The Company has
used the straight-line method to amortize such capitalized costs, and recorded
$11,022 and $18,371 of amortization expense in the three and six months ended
June 30, 1998, respectively.
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 June 30, 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. The Company's 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 June 30, 1998, for income tax return purposes, the Company has
approximately $9,500,000 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 June 30, 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 June 30, 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.
NOTE 6 - NET LOSS PER SHARE
Net loss per share has been computed based upon the weighted average number
of common shares outstanding.
8
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, 1,288,217 stock
options, 1,093,800 warrants and 322,446 5% preferred stock for the six months
ended June 30, 1998, and 741,740 stock options, 830,500 warrants and no 5%
preferred stock for the six months ended June 30, 1997, would be anti-dilutive.
Additionally, at June 30, 1998, the Company's 10% preferred stock may become
convertible into common stock in certain circumstances.
NOTE 7 - PRIVATE PLACEMENT
On May 22, 1998, the Company completed a private placement for gross
proceeds of $3,000,000 with an investor. The Company sold 3,000 shares of 5%
cumulative convertible redeemable preferred stock and warrants to purchase
100,000 shares of common stock. Net proceeds to the Company were $2,678,750
after deducting $321,250 in offering costs.
The preferred stock issued in the above private placement entitles the
holder to voting rights equal to the number of whole shares of common stock into
which the shares of the preferred stock are convertible immediately after the
close of business on the record date fixed for such meeting or the effective
date of such written consent; and specifies a 5% per annum cumulative non-
compounding dividend based on the stated value of $1,000.00 per share. The
Company may redeem the preferred stock at any time within 120 days from May 29,
1998 at a redemption price per share equal to the quotient of $1,000 per share
plus all accrued but unpaid dividends on such shares of 5% preferred stock and
the lower of (i) $16.33 or (ii) 86% of the average closing bid price of the
shares of common stock for the five trading days immediately preceding the 5%
preferred stock redemption date.
Each share of 5% preferred stock shall be convertible, at the option of the
holder thereof, at any time and from time to time, into such number of fully
paid and nonassessable shares of common stock as is determined by dividing
$1,000, plus the amount of any accrued and unpaid dividends the Corporation
elects to pay in common stock, by the lower of (i) $16.33 or (ii) 86% of the
average closing bid price of the shares of common stock for the five (5) trading
days immediately preceding the 5% preferred stock conversion date.
The conversion discount of the preferred stock is considered to be an
additional preferred stock dividend. The maximum discount available of $514,473
(the "Guaranteed Return") is initially recorded as a reduction of preferred
stock and an increase to additional paid-in capital. The Guaranteed Return
reduction to preferred stock will be accreted, as additional dividends, by
recording a charge to income available to common stockholders during 1998 over
the four month period to the earliest date of conversion of the preferred stock.
The Company will also record annual dividends of $50.00 per share as a reduction
of income available to common stockholders, whether or not declared by the Board
of Directors.
Any difference between the highest redemption value ($1,000 per share) and
the recorded value, (excluding the Guaranteed Return discussed above) primarily
offering costs, will be accreted as a charge to income available to common
stockholders during 1998, over the four month period when the Company can redeem
the preferred stock.
The 100,000 common stock purchase warrants issued in the above private
placement entitle the holders to purchase one share of the Company's common
stock for a purchase price of $16.33 per share and any time during the three-
year period commencing on May 22, 1998. The warrants were valued by an outside
valuation firm.
9
NOTE 8 - SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Six months ended
June 30,
------------------------------------
1998 1997
-------- -----
Cash paid for interest $ 3,254 $ 620
Supplemental schedule of non-cash investing and financing activities:
Accretion of preferred stock to redemption value 993,980 -
Preferred stock dividends 142,984 -
Stock issued for services 26,179 586
Stock issued for offering costs 194,000 -
Capital lease for equipment 18,750 -
NOTE 9 - PROPOSED BUSINESS COMBINATIONS
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 therefore (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. DCI
reported revenues of $165,179 (unaudited) for the six months ended June 30, 1998
and $37,180 for the fiscal year ended December 31, 1997 and incurred net losses
of $1,029,655 (unaudited) and $1,144,138 for the same periods, respectively. At
June 30, 1998, DCI had an accumulated deficit of $(7,862,842) (unaudited).
As of June 30, 1998, the Company advanced DCI $575,000 under an unsecured
working capital note with a stated interest rate of 10%. Under the terms of the
note, the purchase price of the proposed merger will be reduced by all such
advances plus accrued interest. If the transaction is not approved by the
stockholders, or is otherwise not completed, no assurances can be made that any
amounts will be collected.
On June 9, 1998, the Company entered into an Agreement and Plan of Merger
with Skyconnect Acquisition Corporation (a wholly owned subsidiary of the
Company) and Skyconnect, Inc. ("Skyconnect"). The Merger Agreement contemplates
that the Company will acquire 100% of the outstanding common stock of Skyconnect
and in consideration therefore (i) will issue up to 1,100,000 shares of the
Company's common stock to the stockholders of Skyconnect and issue 250,000
common stock purchase warrants, (ii) reserve approximately 300,000 shares of the
Company's common stock for issuance pursuant to exercise or conversion of
options, warrants and convertible securities of Skyconnect to be converted into
similar securities of the Company, and (iii) will assume an estimated $8,500,000
of liabilities of Skyconnect. The Merger Agreement is, among other things,
subject to approval by the shareholders of the Company. Skyconnect, a privately
held company located in Louisville, Colorado, is a provider of software-based
products to manage, store and distribute digital video for cable television
operators. Skyconnect reported revenues of $7,923,000 (unaudited) for the three
months ended June 30, 1998 and $11,820,779 for the fiscal year ended March 31,
1998. Skyconnect reported net income of $469,000 (unaudited) for the three
months ended June 30, 1998 and incurred a net loss of $(6,754,688) for the
fiscal year ended March 31, 1998. At June 30, 1998, Skyconnect had an
accumulated deficit of $(31,031,000) (unaudited).
These proposed business combinations are subject to, among other things,
approval of the Company's shareholders. It is the Company's intent to solicit
shareholder approval in a proxy statement to be sent to shareholders as soon as
practicable.
NOTE 10 - NEW ACCOUNTING STANDARDS
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" effective for fiscal years beginning after
June 15, 1999. SFAS No. 133 establishes accounting and reporting standards
requiring that every derivative instrument (including certain derivative
instruments embedded in other contracts) be recorded in the balance sheet as
either an asset or liability measured at its fair value. It also requires that
changes in the derivative's fair value be recognized currently in earnings
unless specific hedge accounting criteria are met. Special accounting for
qualifying hedges allows a derivative's gains and losses to offset related
results on the hedged item in the income statement, and requires that a company
must formally document,
10
designate, and assess the effectiveness of transactions that receive hedge
accounting. SFAS No. 133 may not be applied retroactively, and must be applied
to (a) derivative instruments and (b) certain derivative instruments embedded in
hybrid contracts that were issued, acquired, or substantively modified after
December 31, 1997 (and, at the Company's election, before January 1, 1998).
Management believes that the impact of SFAS No. 133 will not significantly
affect its financial reporting.
In April 1998, the AICPA issued SOP 98-5, "Reporting on the Costs of Start-
Up Activities." This statement is effective for financial statements for fiscal
years beginning after December 15, 1998. In general, SOP 98-5 requires costs of
start-up activities and organization costs to be expensed as incurred. Initial
application of SOP 98-5 should be reported as the cumulative effect of a change
in accounting principle. The Company has not historically utilized such
instruments and has no current plan to do so, and accordingly, management
believes that SOP 98-5 will not have a material impact on the financial
statements.
In June 1997, the 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 adopted SFAS 130 in the first quarter
of 1998. As of June 30, 1998, the adoption has had 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 December 31, 1998 and will first be reflected in the Company's 1998
Annual Report on Form 10-KSB.
NOTE 11 - SUBSEQUENT EVENT
During July 1998, an investor converted 500 shares of the 5% cumulative
convertible redeemable preferred stock. The preferred stock, including accrued
dividends payable of $4,726, was converted into 56,907 shares of the Company's
common stock at a price per share of approximately $8.90.
During July 1998, the Company advanced Skyconnect, Inc. $300,000 for
working capital purposes. The note is secured by accounts receivable and the
Company expects to collect the balance plus accrued interest during the third
quarter of 1998.
11
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 June 30, 1998, the Company had an
accumulated deficit of $9,275,902. 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 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 $721,082 of the Company's revenues during the six months
ended June 30, 1997, representing 62% of the total revenues for such period.
For the six months ended June 30, 1998, revenues from these activities were
insignificant.
During the second quarter of fiscal 1998, the Company implemented a new
pricing structure for its i2u products and services whereby the Company supplies
the equipment and services and the operator provides the infrastructure and
channel for distribution of high-speed Internet access services. This new
structure results in a lower front-end cost for the operator, in consideration
for which the Company expects to receive a higher percentage of access and
transaction fees received from the broadband operator's subscribers. The
Company will require additional working capital and will realize substantially
lower initial revenues in connection with the sale of its i2u products and
services, as the Company will, under this new structure, be providing the
equipment and services instead of selling them to the operators. The Company
expects that this pricing strategy will result in higher
12
revenues in the future as the broadband operator's Internet subscriber base
grows. In addition, 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 fiscal 1998 and
possibly for one or more fiscal years thereafter. There can be no assurance that
such expenditures will result in increased revenue and/or customers. See
Liquidity and Capital Resources for further discussion on proposed financing
activities.
Based on applicable current accounting standards, the Company estimates
that it will be required to record a non-operating expense of approximately
$1,080,000 during fiscal 1998 in connection with the private placement of
$2,675,000 of the Company's 10% preferred stock which occurred during December,
1997 and March, 1998. An additional non-operating expense of approximately
$1,220,000 will be charged to earnings in connection with the private placement
of $3,000,000 of the Company's 5% preferred stock which occurred during May
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 totaling approximately $2,300,000.
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 June 30, For the six months ended June 30,
----------------------------------------- -------------------------------------
1998 1997 1998 1997
------------------- ------------------- --------------- ----------------
Net Sales:
Service sales 30.2% 73.0% 19.3% 75.2%
Hardware/software sales 69.8% 27.0% 80.7% 24.8%
------------------- ------------------- --------------- ----------------
Total net sales 100.0% 100.0% 100.0% 100.0%
Cost of sales:
Cost of services
(as percentage of service sales) 64.9% 62.7% 74.3% 61.1%
Cost of hardware/software
(as percentage of hardware/software sales) 99.0% 84.3% 82.1% 84.5%
------------------- ------------------- --------------- ----------------
Total cost of sales 88.7% 68.5% 80.6% 66.9%
Gross margin 11.3% 31.5% 19.4% 33.1%
------------------- ------------------- --------------- ----------------
Operating expenses:
New market start-up expenses 68.1% - 33.7% -
Sales and marketing expenses 135.2% 37.8% 75.8% 45.6%
Product development expenses 43.6% 35.4% 34.4% 37.7%
General and administrative expenses 284.9% 59.3% 166.2% 63.7%
Depreciation and amortization expenses 35.2% 6.0% 19.6% 6.5%
------------------- ------------------- --------------- ----------------
Total operating expenses 567.0% 138.5% 329.7% 153.5%
Loss from operations (555.7%) (107.0%) (310.3%) (120.4%)
------------------- ------------------- --------------- ----------------
Net loss (544.7%) (99.3%) (304.2%) (110.9%)
Preferred stock dividends (26.8%) - (13.9%) -
Accretion of preferred stock to redemption value (282.1%) - (96.7%) -
------------------- ------------------- --------------- ----------------
Net loss available to common (853.6%) (99.3%) (414.8%) (110.9%)
stockholders
=================== =================== =============== ================
13
THREE AND SIX MONTHS ENDED JUNE 30, 1998 AND 1997
Net sales for the three months ended June 30, 1998 totaled $300,808,
including $90,820 for service sales and $209,988 for hardware and software
sales. Net sales for the six months ended June 30, 1998 totaled $1,028,047,
including $198,392 for service sales and $829,655 for hardware and software
sales. This represents a decrease of 53.6% and 11.8% below net sales for the
1997 three-and-six-month periods, respectively. For the three and six months
ended June 30, 1998, the Company had four and three customers, respectively,
representing 82% and 74%, respectively, of sales. One customer represented 11%
of net sales for the second quarter in 1997 and the Company had no customers
representing sales of more than 10% for the six-month period in 1997. The
decreases in sales for the 1998 periods compared to the 1997 periods, were due
to the discontinuance of the Company's Web site development, maintenance and
hosting activities during the fourth quarter of fiscal 1997 and to the expanded
development of the Company's i2u product and service offerings. During the
second quarter of 1998, the Company implemented a new pricing structure for its
i2u products and services whereby the Company supplies the equipment and
services. This structure results in a lower front-end cost for the operator and
lower initial revenues for the Company, in consideration for which the Company
expects to receive a higher percentage of access and transaction fees received
from the broadband operators' subscribers. The Company's near-term revenues
will be less as a result of the implementation of this new pricing strategy, but
its future revenues should be higher as the subscriber base for Internet access
for the Company's broadband operator customers grows.
Cost of sales as a percentage of net sales was 88.7% for the 1998 three-
month period and 68.5% for the comparable 1997 period. Cost of sales as a
percentage of net sales was 80.6% for the 1998 six-month period and 66.9% 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 operator customers. For the three months ended June 30, 1998, new
market start-up costs were $204,922, or 68.1% of net sales and were $346,269, or
33.7% of net sales for the six months ended June 30, 1998.
Sales and marketing expenses were $406,529 for the three months ended June
30, 1998 and $245,404 for the similar 1997 period. Sales and marketing expenses
as a percentage of net sales for the three-month periods increased from 37.8% in
1997 to 135.2% in 1998. Sales and marketing expenses were $779,498 for the six
months ended June 30, 1998 and $531,272 for the similar 1997 period. Sales and
marketing expenses as a percentage of net sales for the six-month periods
increased from 45.6% in 1997 to 75.8% in 1998. The increase in dollars spent
during the 1998 six-month period was due to the hiring of new sales and
marketing personnel and associated expenditures. During 1998, the Company also
developed initial marketing materials, began lead generation activity and began
to sell its i2u products and services.
Product development expenses were $131,202 for the three months ended June
30, 1998, compared to $229,557 for the 1997 period. Product development expense
as a percentage of net sales for the three-month period increased from 35.4% in
1997 to 43.6% in 1998. Product development expenses were $353,570 for the six
months ended June 30, 1998, compared to $439,501 for the similar 1997 period.
Product development expense as a percentage of net sales for the six-month
period decreased from 37.7% in 1997 to 34.4% in 1998. The Company capitalized
$127,618 and $196,290 of development costs during the three and six month 1998
periods, respectively, related to the continued development of its i2u product.
Product development expenses during the 1998 six-month 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 and
e-commerce products and services.
General and administrative expenses were $857,062 for the three months ended
June 30, 1998, compared to $384,844 for the similar 1997 period. General and
administrative expenses as a percentage of net sales for the three-month period
increased from 59.3% in 1997 to 284.9% in 1998. General and administrative
expenses were
14
$1,708,585 for the six months ended June 30, 1998, compared to
$741,746 for the similar 1997 period. General and administrative expenses as a
percentage of net sales for the six-month period increased from 63.7% in 1997 to
166.2% 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 first quarter in 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 $105,970 for the three months
ended June 30, 1998, compared to $38,500 for the similar 1997 period.
Depreciation and amortization expenses were $201,347 for the six months ended
June 30, 1998, compared to $75,338 for the 1997 similar period. These increases
reflect increases in fixed assets and equipment to support i2u development and
testing as well as to support the growth in the number of employees.
Interest income was $33,225 during the three-month period ended June 30,
1998, compared to $49,969 for the similar 1997 period. Interest income was
$62,414 during the six-month period ended June 30, 1998, compared to $109,623
for the similar 1997 period. The dollar decreases are 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 $2,567,703 for the three-
month period ended June 30, 1998 compared to $644,232 for the similar 1997
period. Net losses available to common stockholders were $4,264,145 for the
six-month period ended June 30, 1998 compared to $1,292,696 for the 1997 period.
The increases in losses reflect non-operating expenses for preferred stock
dividends and accretion of preferred stock to redemption value of $80,585 and
$848,646, respectively, for the three-month period ended June 30, 1998, and
$142,984 and $993,980, respectively, for the six-month period ended June 30,
1998. These non-operating expenses will continue during the balance of fiscal
1998. Additionally, the increases 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, market introduction and the recognition of
revenues from these activities 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 June 30, 1998, the Company had cash and cash equivalents of $2,769,625
and working capital of $3,455,486. The Company has financed its operations and
capital equipment expenditures through a combination of public and private sales
of preferred and common stock, issuing common stock for services, lease
financing, short-term loans and the utilization of trade payables. During the
six months ended June 30, 1998, the Company completed private placements of
22,500 shares of 10% cumulative convertible redeemable preferred stock, stated
value $1 per share, and 3,000 shares of 5% cumulative convertible redeemable
preferred stock, stated value $1,000 per share, which resulted in net proceeds
to the Company of $198,236 and $2,484,750, respectively.
During the six months ended June 30, 1998, the Company purchased $229,762 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 as well as office furniture and the
installation of new accounting software. In anticipation of future growth, the
Company expects to invest a minimum of $270,000 during the balance of fiscal
1998 to purchase additional computer equipment, software and office equipment.
Accounts receivable balances decreased from $701,330 at December 31, 1997
to $577,901 at June 30, 1998, due to in part of 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 $63,265 representing revenue earned and not billed
is shown as accrued revenue receivables at June 30, 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 and second quarters of 1998.
The Company's hardware and software inventory of
15
$62,603 at June 30, 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 decreased to $185,954 at June 30, 1998, from $249,510 at
December 31, 1997, primarily due to receipt of inventory that was prepaid during
December 1997. The major portion of the remaining balance consists of a
software license and electronic sales collateral materials. Deferred assets
represent costs incurred in connection with the proposed mergers with DCI and
Skyconnect. The $124,636 balance at June 30, 1998 is comprised of legal fees
and accounting fees. Trade accounts payable and accrued liabilities at June 30,
1998, decreased to $587,019 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 June 30, 1998 period.
The Company believes that its cash and cash equivalents and working capital
at June 30, 1998, plus the net proceeds of the offerings of preferred stock that
were completed during the first six months of 1998 will be adequate to sustain
operations through October 1998. The Company has entered into a letter of
intent with a placement agent for an offering of its securities for gross
proceeds of $15 to $18 million, which is expected to occur during the third and
fourth quarters 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 June 30,
1998, the Company had an accumulated deficit of $9,275,902. 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. In addition, in accordance with
the Company's new pricing strategy, introduced during the second quarter of
1998, the Company will provide the equipment required for a broadband operator
to provide high-
16
speed Internet access in return for a higher percentage of the broadband
operator's future Internet access and transaction fees. This new pricing
structure will result in increased costs and lower revenues for the Company at
the time that it sells its i2u products and services to broadband operators in
return for anticipated high revenues as the broadband operator's subscriber base
for these services grows. 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. 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 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 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
17
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, 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.
Length of Sales Cycle. The decision to enter the Internet services
provisioning business is often an enterprise-wide decision 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. A significant portion of the Company's 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 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 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
18
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.
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
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.
19
PART II
OTHER INFORMATION
ITEMS 1, 3 and 5. Not Applicable
ITEM 2. Changes in Securities and Use of Proceeds
On May 22, 1998, the Company sold 3,000 shares of its 5% Cumulative
Convertible Preferred Stock, $1,000 stated value, to one investor for $3
million. EDI Securities, Inc. (formerly Cohig & Associates, Inc.) served as the
placement agent for the offering and received a commission equal to 10% of the
gross proceeds of the offering. See Note 7 of the Notes to Financial Statements
for a description of the terms of the Preferred Stock. 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 demand registration rights.
ITEM 4. Submission Of Matters to a Vote of Security Holders.
The Company's 1998 Annual Meeting of Shareholders was held on July 30,
1998. At the meeting the following six persons were elected to serve as
directors of the Company:
Name Vote FOR Vote withheld
- ------------------------------------------------------------------------
R. Steven Adams 3,481,793 9,705
William R. Cullen 3,481,793 9,705
Robert M. Geller 3,481,793 9,705
Robert J. Lewis 3,481,793 9,705
Richard C. Jennewine 3,481,793 9,705
Paul H. Spieker 3,481,793 9,705
Shareholders also approved the following items: (i) an amendment to the
Company's Articles of Incorporation to increase the number of authorized shares
of capital stock from 15,000,000 to 25,000,000 shares and to increase the number
of authorized shares of common stock, no par value, from 10,000,000 to
20,000,000 shares--3,460,607 shares voting FOR such amendment, 22,285 shares
voting against and 16,200 shares abstaining; (ii) the issuance of the Company's
common stock in connection with the terms of the Company's Securities Purchase
Agreement dated May 22, 1998, between the Company and Arrow Investors LLC--
1,683,671 shares voting FOR approval, 20,135 shares voting against, 15,845
shares abstaining and 2,378,084 shares broker non-votes; (iii) the issuance of
the Company's common stock in connection with an anticipated private offering of
common stock--1,716,762 shares voting FOR approval, 21,235 shares voting
against, 16,000 shares abstaining and 2,342,738 shares broker non-votes; (iv) an
increase from 1,100,000 shares to 2,800,000 shares in the number of shares of
common stock reserved for issuance pursuant to the Company's Stock Option Plan
of 1995--1,701,188 shares voting FOR approval, 36,115 shares voting against,
16,360 shares abstaining and 2,343,072 shares broker non-votes; and (v) the
approval of Arthur Andersen LLP as the independent auditors of the Company for
the fiscal year ending December 31, 1998--3,492,337 shares voting FOR, 4,900
voting against and 2,070 shares abstaining."
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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: August 14, 1998 By /s/ Thomas S. Plunkett
--------------------------
Vice President and
Chief Financial Officer
/s/ Stuart J. Lucko
--------------------------
Controller
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