UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-QSB
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the period ended June 30, 2005
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______ to _______.
Commission File Number 333-16031
INCENTRA SOLUTIONS, INC.
------------------------
(Exact name of small business issuer as specified in its charter)
Nevada 86-0793960
------ ----------
(State or other jurisdiction (I.R.S. Employer
of (incorporation or organization) Identification No.)
1140 PEARL STREET
BOULDER, COLORADO 80302
-----------------------
(Address of principal executive offices)
(303) 449-8279
--------------
(Issuer's telephone number)
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 preceding 12
months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days. Yes [X] No []
As of August 10, 2005, 13,018,661 shares of the issuer's common stock, $.001 par
value per share, and 2,466,971 shares of the issuer's Series A preferred stock,
$.001 par value per share, were outstanding.
Transitional Small Business Disclosure Format (check one): Yes [ ] No [X]
1
PART I. FINANCIAL INFORMATION
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
JUNE 30, 2005
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents $ 2,058,585
Accounts receivable, net of allowance for doubtful accounts of $260,000 12,309,757
Other current assets 1,036,076
-------------
Total current assets 15,404,418
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Property and equipment, net 2,366,712
Capitalized software development costs, net 1,655,837
Intangible assets, net 14,916,003
Goodwill 14,482,287
Other assets 894,149
-------------
34,314,988
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TOTAL ASSETS $ 49,719,406
=============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of note payable, capital leases and other long-term obligations $ 4,495,929
Accounts payable 9,612,801
Accrued expenses 3,720,186
Current portion of deferred revenue 1,378,109
-------------
Total current liabilities 19,207,025
-------------
Note payable, capital leases and other long-term obligations, net of current portion 6,317,932
Deferred revenue, net of current portion 109,105
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6,427,037
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TOTAL LIABILITIES 25,634,062
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Commitments and contingencies
Series A convertible redeemable preferred stock, $.001 par value, $31,500,000 liquidation preference,
2,500,000 shares authorized, 2,466,971 shares issued and outstanding 23,309,550
-------------
Shareholders' equity:
Preferred stock, nonvoting, $.001 par value, 2,500,000 shares --
authorized, none issued or outstanding
Common stock, $.001 par value, 200,000,000 shares authorized, 13,030,446 shares issued, --
12,887,082 shares outstanding, 143,364 shares in treasury 12,887
Additional paid-in capital 124,021,141
Accumulated other comprehensive loss (134,766)
Accumulated deficit (123,123,468)
-------------
TOTAL SHAREHOLDERS' EQUITY 775,794
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TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 49,719,406
=============
See accompanying notes to unaudited condensed consolidated financial statements.
2
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(UNAUDITED)
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2005 2004 2005 2004
---- ---- ---- ----
Revenues:
Products $ 13,788,519 $ 30,500 $ 17,020,031 $ 402,000
Services 3,810,713 1,867,531 6,586,364 3,859,827
------------ ------------ ------------ ------------
TOTAL REVENUES 17,599,232 1,898,031 23,606,395 4,261,827
------------ ------------ ------------ ------------
Cost of revenue:
Products 10,010,843 -- 11,287,217 --
Services 2,494,582 1,337,362 4,282,191 2,549,699
------------ ------------ ------------ ------------
Total cost of revenue 12,505,425 1,337,362 15,569,408 2,549,699
------------ ------------ ------------ ------------
GROSS MARGIN 5,093,807 560,669 8,036,987 1,712,128
------------ ------------ ------------ ------------
Selling, general and administrative 5,361,134 2,046,528 9,388,507 4,101,731
Amortization 806,028 237,476 1,591,309 474,952
Depreciation 120,249 37,162 191,393 82,079
Impairment of goodwill -- 136,852 -- 198,280
------------ ------------ ------------ ------------
6,287,411 2,458,018 11,171,209 4,857,042
------------ ------------ ------------ ------------
LOSS FROM OPERATIONS (1,193,604) (1,897,349) (3,134,222) (3,144,914)
------------ ------------ ------------ ------------
Other income (expense):
Interest income 3,516 659 25,947 5,818
Interest expense (610,000) (697,705) (1,171,310) (1,391,219)
Other income 11,425 34,173 378,167 87,188
Foreign currency transaction (loss) gain (8,464) 2,244 73,725 1,932
------------ ------------ ------------ ------------
(603,523) (660,629) (693,471) (1,296,281)
------------ ------------ ------------ ------------
LOSS BEFORE INCOME TAX EXPENSE (1,797,127) (2,557,978) (3,827,693) (4,441,195)
Income tax expense (559,000) -- (877,000) --
------------ ------------ ------------ ------------
NET LOSS (2,356,127) (2,557,978) (4,704,693) (4,441,195)
------------ ------------ ------------ ------------
Deemed dividends on redeemable preferred stock -- (149,589) -- (297,534)
Accretion of redeemable preferred stock to redemption amount (654,392) (7,833) (1,308,784) (15,666)
------------ ------------ ------------ ------------
NET LOSS APPLICABLE TO COMMON SHAREHOLDERS $ (3,010,519) $ (2,715,400) $ (6,013,477) $ (4,754,395)
============ ============ ============ ============
COMPREHENSIVE NET LOSS
Net Loss $ (2,356,127) $ (2,557,978) $ (4,704,693) $ (4,441,195)
Foreign currency translation adjustments (76,717) -- (153,950) --
------------ ------------ ------------ ------------
$ (2,432,844) $ (2,557,978) $ (4,858,643) $ (4,441,195)
============ ============ ============ ============
Weighted average number of common shares 12,703,068 1,953,308 11,901,066 1,950,114
outstanding - basic and diluted =========== ========== =========== ============
Basic and diluted net loss per share applicable to common shareholders $ (0.24) $ (1.39) $ (0.51) $ (2.44)
============ ============ ============ ============
See accompanying notes to unaudited condensed consolidated financial statements.
3
INCENTRA SOLUTIONS, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
SIX MONTHS ENDED JUNE 30,
2005 2004
---- ----
Cash flows from operating activities:
Net loss $(4,704,693) $(4,441,195)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation 792,959 890,213
Amortization of intangible assets and software development costs 1,839,492 653,563
Amortization of non-cash loan discount 12,735 7,643
Stock-based compensation expense 263,753 88,618
Non-cash interest expense 959,402 --
Non-cash interest expense on Series C mandatorily redeemable preferred stock liability -- 1,335,650
Non-cash income tax expense 877,000 --
Share of losses of Front Porch Digital, Inc. and related impairment of goodwill -- 198,280
Loss on disposal of assets and other (25,205) 9,541
Bad debt expense 20,787 126,924
Gain on revaluation of derivative warrant liability (390,280) --
Changes in operating assets and liabilities, net of business acquisitions:
Accounts and other receivables (971,197) (277,073)
Other current assets (241,418) (5,374)
Other assets 29,524 (8,218)
Accounts payable 711,812 330,023
Accrued liabilities (49,099) (956)
Deferred revenue 83,955 (463,093)
Other liabilities (328,128) (6,932)
----------- -----------
Net cash used in operating activities (1,118,601) (1,562,386)
----------- -----------
Cash flows from investing activities:
Purchases of property and equipment (516,745) (750,750)
Capitalized software development costs (729,002) (353,729)
Proceeds from sale of property and equipment 750 134,758
Cash acquired in Incentra of CA acquisition (Note 2) 1,597,498 --
Cash acquired in PWI acquisition (Note 2) 74,297 --
Net change in restricted cash (366) (317)
Maturies of short-term investments -- 3,793,099
----------- -----------
Net cash provided by investing activities 426,432 2,823,061
----------- -----------
Cash flows from financing activities:
Proceeds from bank line of credit 862,000 --
Proceeds from lease line of credit 497,667
Payments on capital leases, notes payable and other long term liabilities (1,594,954) (410,055)
Proceeds from exercise of stock options and purchase of restricted stock -- 1,418
----------- -----------
Net cash used in financing activities (235,287) (408,637)
----------- -----------
Effect of exchange rate changes on cash and cash equivalents (82,417) --
----------- -----------
Net (decrease) increase in cash and cash equivalents (1,009,873) 852,038
Cash and cash equivalents at beginning of period 3,068,458 2,201,192
----------- -----------
Cash and cash equivalents at end of period $ 2,058,585 $ 3,053,230
=========== ===========
Supplemental disclosures of cash flow information:
Cash paid during the period for interest $ 199,174 $ 34,285
Supplemental disclosures of non-cash investing and financing activities:
Net assets acquired in Incentra of CA acquisition, excluding cash (Note 2) 6,097,510 --
Net assets acquired in PWI acquisition, excluding cash (Note 2) 4,310,840 --
Conversion of notes payable and accrued interest in exchange for common stock 400,000
Reclassification of derivative warrant liability to equity 1,910,254
Purchases of property and equipment included in accounts payable 118,608 205,492
See accompanying notes to unaudited condensed consolidated financial statements.
4
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND BASIS OF PRESENTATION
Incentra Solutions, Inc. (which is referred to herein together with its
subsidiaries as ("we", "us" or "our"), formerly Front Porch Digital, Inc.
("FPDI" or "Front Porch"), was organized and incorporated in the state of
Nevada. On October 25, 2004, we changed our name from Front Porch Digital, Inc.
to Incentra Solutions, Inc.
We recently completed three acquisitions: On August 18, 2004, we acquired
ManagedStorage International, Inc., a Delaware corporation incorporated in March
2000 ("MSI"); on February 18, 2005, we acquired Incentra of CA, formally known
as STAR Solutions of Delaware, Inc., a privately-held Delaware corporation
("Incentra of CA "); and on March 30, 2005, we acquired PWI Technologies, Inc.,
a privately-held Washington corporation ("PWI"). The MSI acquisition was
accounted for as a reverse merger, and therefore, MSI was deemed to be the
acquirer for accounting purposes. Accordingly, the condensed consolidated
financial statements presented herein include the results of operations of MSI
for all periods presented, and include the results of operations of the acquired
companies from the dates of the acquisitions forward.
We are a provider of complete solutions for an enterprise's data protection
needs. We supply a broad range of storage products and storage management
services to broadcasters, enterprises and information technology service
providers worldwide. We market our products and services to broadcasters under
the trade name Front Porch Digital ("Front Porch") and to service providers and
enterprise clients under the trade names ManagedStorage International, Incentra
Solutions of CA and PWI Technologies. Front Porch provides unique software and
professional services solutions for digital archive management to broadcasters
and media companies. MSI provides outsourced storage solutions, including
engineering, hardware and software procurement and remote storage operations
services. Incentra of CA and PWI are systems integrators that provide
Information Technology ("IT") products, professional services and outsourcing
solutions to enterprise customers located primarily in the western United
States. Our customers are located in North America, Europe, Asia and the Pacific
Rim.
On April 12, 2005, our Board of Directors (the "Board") and the holders of the
required number of shares of our capital stock approved an amendment to our
Articles of Incorporation to effect a one-for-ten reverse stock split effective
June 9, 2005. All references to shares, options, and warrants in the three and
six months ended June 30, 2005 and in prior periods, have been adjusted to
reflect the post-reverse split amounts. Our common stock now trades on the
Over-the-Counter Bulletin Board under the trading symbol "ICNS".
The accompanying unaudited condensed consolidated financial statements have been
prepared by us in accordance with accounting principles generally accepted in
the United States of America for interim financial information and pursuant to
the rules and regulations of the Securities and Exchange Commission ("SEC").
Certain information and note disclosures normally included in financial
statements prepared in accordance with accounting principles generally accepted
in the United States of America have been condensed or omitted pursuant to such
regulations. The unaudited condensed
5
consolidated financial statements reflect all adjustments and disclosures that
are, in the opinion of management, necessary for a fair presentation. All such
adjustments are of a normal recurring nature. These interim condensed
consolidated financial statements should be read in conjunction with a reading
of the consolidated financial statements and notes thereto included in our
Annual Report on Form 10-KSB filed with the SEC on April 6, 2005, for the year
ended December 31, 2004.
Certain amounts in the 2004 financial statements have been reclassified to
conform to the 2005 presentation. We do not believe the effects of such
reclassifications are material. Operating results for the three or six months
ended June 30, 2005 are not necessarily indicative of the operating results to
be expected for the year ending December 31, 2005.
MANAGEMENT'S PLANS
Our 2005 operating plan and the execution thereof is focused on increasing
revenue, controlling costs, and conserving cash; however, there can be no
assurance that we will be able to meet the operational and financial
requirements of our operating plan. Our 2005 plan also includes growth through
our recent business acquisitions (Note 2). We cannot predict with certainty the
expected revenue, gross profit margin, net loss, and/or usage of cash and cash
equivalents as a result of these acquisitions. However, we believe that our cash
and cash equivalents and working capital will provide sufficient capital
resources to fund our operations, debt service requirements and working capital
needs at least through June 30, 2006.
STOCK-BASED COMPENSATION
We apply the intrinsic value-based method of accounting prescribed by Accounting
Principles Board Opinion No. 25 (APB 25), ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES, and related interpretations, including Financial Accounting Standards
Board ("FASB") Interpretation No. 44 (FIN 44), ACCOUNTING FOR CERTAIN
TRANSACTIONS INVOLVING STOCK COMPENSATION, AN INTERPRETATION OF APB OPINION NO.
25, to account for our fixed-plan stock options. Under this method, compensation
expense is generally recorded on the date of grant only if the current market
price of the underlying stock exceeds the exercise price. Statement of Financial
Accounting Standards ("SFAS") No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION
and SFAS No. 148, ACCOUNTING FOR STOCK-BASED COMPENSATION - TRANSITION AND
DISCLOSURE, AN AMENDMENT OF FASB STATEMENT NO. 123, established accounting and
disclosure requirements using a fair value-based method of accounting for
stock-based employee compensation plans. As permitted by existing accounting
standards, we have elected to continue to apply the intrinsic value-based method
of accounting described above, and have adopted only the disclosure requirements
of Statement 123, as amended. The following table illustrates the effect on net
loss if the fair value-based method had been applied to all outstanding and
unvested awards in the three and six months ended June 30, 2005 and 2004. All
amounts except per share amounts in (000's):
6
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
2005 2004 2005 2004
------- ------- ------- -------
Net loss before deemed dividends and accretion on preferred stock, as reported $(2,356) $(2,558) $(4,705) $(4,441)
Add stock-based employee compensation expense included in reported
net loss 108 44 264 89
Deduct total stock-based employee compensation expense determined under
fair value-based method for all awards (688) (47) (1,198) (94)
------- ------- ------- -------
Pro forma net loss before deemed dividends and accretion on preferred stock $(2,936) $(2,561) $(5,639) $(4,446)
======= ======= ======= =======
Net loss per weighted average common share outstanding - basic and
diluted - pro forma $ (0.28) $ (1.39) $ (0.58) $ (2.44)
======= ======= ======= =======
Net loss per weighted average common share outstanding - basic and
diluted - as reported $ (0.24) $ (1.39) $ (0.51) $ (2.44)
======== ======= ======= =======
In determining the fair value of stock options granted by us during the three
and six months ended June 30, 2005, and thus determining pro forma compensation
expense under the fair value method, we utilized the Black-Scholes valuation
model with the following weighted average assumptions: dividend yield of 0%,
risk free interest rate of 3.64%, expected volatility of 111%, and expected
lives of three years. The weighted average fair value of options granted during
2005 is $2.10 per option.
In determining the fair value of stock options granted by MSI for the three and
six months ended June 30, 2004, we utilized the Black-Scholes valuation model to
determine pro forma compensation expense under the fair value method with the
following weighted average assumptions: dividend yield of 0%, risk free interest
rate of 4.76%, expected volatility of 0.001%, and expected lives of ten years.
The weighted average fair value of options granted during 2004 was $3.20.
For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the vesting period of the related option.
Previously recognized compensation expense for forfeited options is included as
a reduction of compensation expense in the period of forfeiture.
On August 16, 2004, our Board of Directors approved, and on April 1, 2005, our
stockholders approved by majority written consent, an amendment to our 2000
Equity Incentive Plan (the "Plan") to increase the maximum number of shares of
our common stock available for issuance there under from 600,000 shares to
2,265,000 shares.
FOREIGN CURRENCY TRANSLATION AND TRANSACTIONS
The accounts of our international subsidiary, Front Porch Digital International,
SAS ("FPD International"), are translated using the exchange rate in effect at
the balance sheet date, and the results of operations are translated at the
average exchange rates during the period. For the six months ended June 30,
2005, we reported a cumulative translation loss of $153,950 as a component of
accumulated other comprehensive loss. We are also subject to foreign exchange
transaction exposure when our subsidiary transacts business in a currency other
than its own functional currency. The effects of exchange rate fluctuations in
remeasuring foreign currency transactions for the three months ended June 30,
2005 and 2004 was a loss of $8,500 and a gain of $2,200, respectively. The
effect of exchange rate fluctuations in remeasuring foreign currency
transactions for the six months ended June 30, 2005 and 2004 was a loss of
$1,000 and a gain of $2,000, respectively.
During 2004, we began managing our foreign currency cash flow exposure through
the use of $/Euro forward contracts, which are considered derivative instruments
and which are recorded as either an asset or liability, measured at fair value.
We recognize changes in fair value of the contracts currently
7
in the statements of operations. We recorded a realized gain of approximately $0
and $74,600 for the three and six months ended June 30, 2005, respectively,
which represented the change in the fair value of one foreign currency forward
contract related to the difference between changes in the spot and forward rates
excluded from the assessment of hedge effectiveness. This contract was settled
on April 1, 2005. Currently, there are no forward contracts outstanding.
ACCOUNTING FOR OBLIGATIONS AND INSTRUMENTS POTENTIALLY SETTLED IN THE
COMPANY'S COMMON STOCK
We account for obligations and instruments potentially settled in our stock in
accordance with Emerging Issues Task Force ("EITF") No. 00-19, ACCOUNTING FOR
DERIVATIVE FINANCIAL INSTRUMENTS INDEXED TO, AND POTENTIALLY SETTLED IN A
COMPANY'S OWN STOCK ("EITF 00-19"). This issue addresses the initial balance
sheet classification and measurement of contracts that are indexed to, and
potentially settled in, our stock.
Under EITF 00-19, contracts are initially classified as equity or as either
assets or liabilities, depending on the situation. All contracts are initially
measured at fair value and subsequently accounted for based on the then-current
classification. Contracts initially classified as equity do not recognize
subsequent changes in fair value as long as the contracts continue to be
classified as equity. For contracts classified as assets or liabilities, we
report changes in fair value in earnings and disclose these changes in the
financial statements as long as the contracts remain classified as assets or
liabilities. If contracts classified as assets or liabilities are ultimately
settled in shares, any previously reported gains or losses on those contracts
continue to be included in earnings.
At December 31, 2004, our authorized and unissued common shares were
insufficient to settle these contracts. As a result, we classified the value of
these contracts as a liability. As a result of the one-for-ten reverse stock
split on June 9, 2005, there are now sufficient authorized and unissued common
shares to settle these contracts. Accordingly, the fair value of the warrants at
the effective date of the stock split was reclassified to additional paid-in
capital. During the three and six months ended June 30, 2005 we recorded a gain
of $48,785 and $390,280, respectively, on these contracts. The appropriateness
of the classification of these contracts is reassessed at each balance sheet
date.
IMPAIRMENT OF LONG-LIVED ASSETS
Long-lived tangible and intangible assets that do not have indefinite lives,
such as fixed assets and intellectual property, are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of
such assets may not be recoverable. Determination of recoverability is based on
an estimate of undiscounted future cash flows resulting from the use of the
asset and its eventual disposition. Measurement of an impairment loss for such
long-lived assets is based on the fair value of the asset.
Goodwill and other intangible assets with indefinite lives are not amortized and
are subject to write downs charged to results of operations only when their
carrying amounts are determined to be more than their estimated fair values
based upon impairment tests that are required to be made annually or more
frequently under certain circumstances. Fair values are determined based on
models that incorporate estimates of future probability and cash flows.
As of June 30, 2005, we believe there were no indicators of a possible
impairment, and accordingly, no impairment tests were performed and no
impairment losses were recorded. For the three and six months ended June 30,
8
2004, MSI recorded impairment losses of $136,852 and $198,280, respectively.
REVENUE RECOGNITION
Revenue is recognized when all of the following criteria are met: persuasive
evidence of an agreement exists, delivery has occurred or services have been
rendered, the sales price is fixed or determinable, and collectibility is
reasonably assured.
We license software under license agreements and provide professional services,
including training, installation, consulting and maintenance. License fee
revenues are recognized when a license agreement has been signed, the software
product has been shipped, the fees are fixed and determinable, collection is
reasonably assured, and no significant vendor obligations remain.
We allocate revenue to each component of a contract based on objective evidence
of its fair value, as established by management. Because licensing of software
is generally not dependent on the professional services portion of the contract,
software revenue is generally recognized upon delivery, unless a contract exists
with the customer requiring customer acceptance.
Fees for first call maintenance agreements are recognized ratably over the terms
of the agreements. Maintenance is generally billed in advance, resulting in
deferred revenue.
We also provide software-related professional services. Services are generally
provided on a time-and-materials basis and revenue is recognized as the services
are provided.
Revenues from storage services are recognized at the time the services are
provided and are billed on a monthly basis. Fees received for up-front
implementation services are deferred and recognized over the term of the
arrangement. Deferred revenue is recorded for billings sent to or paid by
customers for which we have not yet performed the related services.
Revenues from product sales, including the resale of third-party maintenance
contracts, are recognized when shipped. Consulting revenues are recognized when
the services are performed.
SOFTWARE DEVELOPMENT COSTS
We account for costs related to software developed for internal use and marketed
for external use in accordance with SFAS No. 86, ACCOUNTING FOR THE COSTS OF
COMPUTER SOFTWARE TO BE SOLD, LEASED, OR OTHERWISE MARKETED. MSI's Gridworks
software product is used internally for providing services to our customers and
is also marketed separately as a stand-alone product. FPDI's DIVArchive software
product is marketed solely as a stand-alone product. As required by SFAS No. 86,
we capitalize costs in developing software products upon determination that
technological feasibility has been established for the product, if that product
is to be sold, leased or otherwise marketed. Costs incurred prior to the
establishment of technological feasibility are charged to research and
development expense. When the product or enhancement is available for general
release to customers, capitalization is ceased, and previously capitalized costs
are amortized based on current and future revenue for the product, but with an
annual amortization amount at least equal to the straight-line, typically three
years. For the three and six months ended June 30, 2005 capitalized software
development costs, which related primarily to enhancements to our Gridworks and
DIVArchive software solutions, totaled $329,691 and $729,002, respectively. For
the three months ended June 30, 2005 and 2004, $130,449 and $91,505,
respectively, of software
9
development costs were charged to expense. For the six months ended June 30,
2005 and 2004, $248,182 and $178,611, respectively, of software development
costs were charged to expense. As of June 30, 2005, the unamortized portion of
software development costs was $1,655,837.
INCOME TAX
Income tax expense recognized for the three and six months ended June 30, 2005,
represented income tax expense on FPD International, our wholly-owned French
subsidiary. We are currently in the process of creating an agreement with FPD
International for the allocation of costs related to its sale of our proprietary
software solutions. Any such agreement is subject to acceptance by the French
taxing authorities. We expect that we will be able to implement this agreement
in the fourth quarter of 2005, and therefore allocate the appropriate costs to
FPD International, which we anticipate would serve to significantly reduce our
income tax exposure for the remainder of the year. However, there can be no
assurance that the French taxing authorities will accept this agreement with FPD
International and that we will be able to reduce this income tax expense. Our
income tax expense is a non-cash item due to the utilization of our net
operating loss carryforwards in France.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 123(R), SHARE-BASED PAYMENT, which addresses the accounting for share-based
compensation transactions. SFAS No. 123(R) eliminates the ability to account for
share-based compensation transactions using APB 25, and generally requires
instead that such transactions be accounted and recognized in the statement of
operations based on their fair value. SFAS No. 123(R) will be effective for
public companies that file as small business issuers as of the first interim or
annual reporting period that begins after December 15, 2005. We are currently
evaluating the provisions of this standard. However, we expect that the
implementation of this standard will have a material impact on our financial
position and results of operations.
In May 2005, the FASB issued SFAS No. 154, ACCOUNTING CHANGES AND ERROR
CORRECTIONS, which changes the requirements for the accounting and reporting of
a change in accounting principle and applies to all voluntary changes in
accounting principles. It also applies to changes required by an accounting
pronouncement in the unusual instance that the pronouncement does not include
specific transition provisions. When a pronouncement includes specific
transition provisions, those provisions should be followed. APB No. 20 required
that most voluntary changes in accounting principle be recognized by including
in net income of the period of the change the cumulative effect of changing to
the new accounting principle. This statement requires retrospective application
to prior period financial statements of changes in accounting principles, unless
it is impracticable to determine either the period-specific effects or the
cumulative effect of the change. The provisions of SFAS No. 154 are effective
for fiscal years beginning after December 15, 2005. We do not expect this
statement to have a material impact on our financial position or results of
operations.
(2) ACQUISITIONS
(A) ACQUISITION OF INCENTRA OF CA, FORMALLY KNOWN AS STAR SOLUTIONS OF
DELAWARE, INC.
On February 18, 2005 (the "STAR Closing Date"), we acquired all of the
outstanding capital stock of Incentra of CA. The acquisition was effected
pursuant to an Agreement and Plan of Merger (the "STAR Merger Agreement"). The
results of operations of Incentra of CA are included in our consolidated
10
financial statements beginning on February 18, 2005.
Pursuant to the STAR Merger Agreement, the purchase price consisted of (i) a
cash payment of $1,422,000, (ii) the issuance of 1,261,756 unregistered shares
of our common stock valued at $3,136,364 (based upon the market price three days
before and after the acquisition date) and (iii) the issuance of an unsecured
convertible promissory note for $2,500,000 (the "STAR Note"). In addition, we
paid $78,000 to the sole remaining stockholder of Incentra OF CA in exchange for
all shares of capital stock of Incentra OF CA held by such stockholder. We paid
approximately $400,000 in investment banking fees associated with the
transaction.
Interest on the STAR Note accrues at an annual rate of 0.5%, which has been
discounted to reflect a fair value rate of interest. The remaining principal of
$2,374,139 is payable in eight consecutive quarterly payments of $251,722,
commencing on August 1, 2005, and a single payment of $377,583 on August 1, 2007
(each of the foregoing dates, a "STAR Payment Due Date"). We elected not to make
the August 1, 2005 payment within the grace period allowed under the STAR Note,
which created an event of default on the STAR Note as of August 11, 2005. We
have not received notice of default or acceleration from the STAR note holder.
We elected not to make the scheduled payment as we are in the process of
negotiating post-closing adjustments to the purchase, which could have a
significant impact on the amount and terms of the STAR Note. As of the balance
sheet date, we have reclassified approximately $1.3 million of the debt to
current liabilities based on the default, as it was not cured within the 10-day
grace period. Management does not believe the debt will be paid in one year from
the balance sheet date, however, the reclassification on the balance sheet was
made as the debt is now callable.
All or a portion of the outstanding principal and interest due under the STAR
Note may be converted by the holder into shares of our common stock at any time
from the end of each calendar quarter immediately preceding a STAR Payment Due
Date until and including one day prior to such STAR Payment Due Date. The STAR
Note is initially convertible at a conversion price equal to the greater of (i)
$4.00 or (ii) seventy percent (70%) of the average closing price of our common
stock, as reported on the Over-The-Counter Bulletin Board, for the ten (10)
consecutive trading days ending on and including the last day of the calendar
quarter immediately preceding the applicable STAR Payment Due Date. As of June
30, 2005, the STAR Note was convertible into a maximum of 593,535 shares of our
common stock. Our obligations under the STAR Note are not secured by any of our
assets.
The STAR Note provides that all unpaid principal and accrued interest shall, at
the option of the holder and without notice, become immediately due and payable
upon the occurrence of an event of default (as defined in the STAR Note). Such
events of default include the occurrence of any of the following events: (i)
failure to pay within ten (10) days after the applicable due date any amounts
payable under the STAR Note, (ii) an assignment for the benefit of creditors, or
(iii) failure to perform any material covenant under the STAR Merger Agreement,
the registration rights agreement or the consulting agreement described below or
any other material agreement between us and the seller. Principal amounts not
paid when due (subject to applicable cure periods) bear interest at the rate of
twelve percent (12%) per annum.
Concurrent with the consummation of the acquisition, we entered into a
registration rights agreement with the seller, pursuant to which, at any time
after March 1, 2006, the seller shall have the right to cause us to register
under the Securities Act of 1933, as amended, the shares of common stock issued
to the seller in the acquisition and the shares of common stock issuable upon
conversion of the STAR Note. The agreement also provides that, after March 1,
2006, the seller shall have `piggy-back' registration rights.
The following represents the preliminary purchase price allocation at the date
of the Incentra of CA acquisition:
11
Cash and cash equivalents $ 1,598,000
Other current assets 825,000
Property and equipment 20,000
Other assets 7,000
Goodwill 8,122,000
Other intangible assets (3-5 year lives) 540,000
Current liabilities (1,517,000)
Other liabilities (1,900,000)
-----------
Total purchase price $ 7,695,000
===========
The purchase price allocation is not considered final as of the date of this
report. However, we believe the final purchase price allocation will not be
materially different than that presented herein. In connection with the
acquisition, on February 18, 2005, Incentra of CA obtained a revolving line of
credit from a bank that provides for borrowings until March 1, 2007, of up to
$5,000,000 (Note 7(c)). This line of credit and all the related accrued interest
was paid in full on July 5, 2005, in connection with the New Laurus Financing
Agreement as discussed in Note 8.
(B) ACQUISITION OF PWI TECHNOLOGIES, INC.
On March 30, 2005 (the "PWI Closing Date"), we acquired all of the outstanding
capital stock of PWI. The acquisition was effected pursuant to a Stock Purchase
Agreement, dated as of the PWI Closing Date (the "PWI Stock Purchase
Agreement").
The purchase price of PWI consisted of $2,300,000 in cash and 841,934 shares of
our common stock valued at $1,683,868 (based upon the market price three days
before and after the acquisition date). In addition, the former PWI shareholders
have the opportunity to earn an additional $200,000 in cash and $1,000,000 in
our common stock based upon achieving certain earn out requirements. Should PWI
exceed the earn-out requirements, its former shareholders can earn additional
common stock having a value equal to PWI's EBITDA contribution over the earn out
requirement. We paid approximately $300,000 in investment banking fees in
connection with the transaction.
Concurrently with the consummation of the acquisition, we granted registration
rights with respect to the shares of our common stock issued in the acquisition.
Pursuant to the registration rights agreement, at any time after March 31, 2006,
the holders of such rights shall have the right to cause us to register under
the Securities Act of 1933, as amended, the shares of our common stock issued on
the PWI Closing Date and the shares of common stock issuable pursuant to the
earn-out described above. The agreement also provides that, after March 31,
2006, the holders shall have "piggy-back" registration rights with respect to
such shares.
In connection with the consummation of the acquisition, the Chief Executive
Officer of PWI prior to the acquisition was appointed President of PWI. PWI
entered into an "at-will" employment agreement dated as of the PWI Closing Date
that provides that the President will receive an initial annual base salary of
$211,500. The employment agreement also provides that the President may
terminate the agreement upon thirty (30) days prior written notice and that PWI
may terminate employment, with or without cause, at any time upon written
notice. In addition, the President's right to receive his pro rata share of the
earn-out described above is subject to his continued employment
12
with PWI for a period of at least one year from the date of the agreement,
except in cases of his death or disability.
The following represents the preliminary purchase price allocation at the date
of the PWI acquisition:
Cash and cash equivalents $ 74,000
Other current assets 7,010,000
Property and equipment 174,000
Other assets 28,000
Goodwill 6,361,000
Other intangible assets (3-5 year lives) 310,000
Current liabilities (7,157,000)
Other liabilities (2,415,000)
-----------
Total purchase price $ 4,385,000
===========
The purchase price allocation is not considered final as of the date of this
report. However, we believe the final purchase price allocation will not be
materially different than that presented herein.
Financing for the cash component of the acquisition was provided by a bank
through an existing line of credit ("LOC") that was established as part of the
acquisition of Incentra of CA. In connection with the financing, the LOC was
amended to make PWI a co-borrower under the agreements and to modify certain
financial covenants to accommodate the addition of PWI to the LOC. The LOC and
all related accrued interest was paid in full on July 5, 2005, in connection
with the New Laurus Financing Agreement, as discussed in Note 8 to these
condensed consolidated financial statements.
(C) ACQUISITION OF MANAGEDSTORAGE INTERNATIONAL, INC.
On August 18, 2004 (the "MSI Acquisition Date"), we acquired all of the
outstanding capital stock of MSI. The acquisition of MSI by us was accounted for
as a reverse merger because on a post-merger basis, the former MSI shareholders
held, immediately following the acquisition on the MSI Acquisition Date, a
majority of our outstanding common stock on a voting and diluted basis. As a
result, MSI was deemed to be the acquirer for accounting purposes. Accordingly,
the condensed consolidated financial statements presented herein include the
financial statements of MSI for all periods prior to the MSI Acquisition Date
and the financial statements of the consolidated companies from the MSI
Acquisition Date forward. Historical share and per share amounts for periods
prior to the MSI Acquisition Date have been retroactively restated to reflect
the exchange ratio established in the transaction, in a manner similar to a
reverse stock split, with the difference in par values being recorded as an
offset to additional paid-in capital. The restated consolidated accumulated
deficit of the accounting acquirer (MSI) has been carried forward after the MSI
Acquisition. The MSI Acquisition was also accounted for as a step acquisition as
it occurred in multiple steps over the period from July 31, 2002, when MSI sold
to us its French subsidiary. After the acquisition of MSI, the former MSI
shareholders beneficially owned approximately 64% of our outstanding common
stock, after giving effect to the conversion of the Series A Preferred Stock.
13
(D) PROFORMA RESULTS
The following unaudited pro forma financial information presents our combined
results of operations as if the acquisitions described in (A), (B) and (C) above
had occurred as of the beginning of each of the periods reported below. The
unaudited pro forma financial information is not intended to represent or be
indicative of the consolidated results of operations that would have been
reported by us had the acquisitions been completed as of the beginning of the
periods presented, and should not be taken as representative of our future
consolidated results of operations or financial condition. Pro forma results
were as follows for the three and six months ended June 30, 2005 and 2004:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2005 JUNE 30, 2004 JUNE 30, 2005 JUNE 30, 2004
------------- ------------- ------------- -------------
Revenue $ 17,599,232 $ 13,860,231 $ 34,050,155 $ 28,136,898
Cost of revenue 12,505,425 9,510,887 24,475,325 19,638,441
------------ ------------ ------------ ------------
Gross margin 5,093,807 4,349,344 9,574,830 8,498,457
Operating expenses 6,287,411 6,883,428 12,667,511 12,704,662
------------ ------------ ------------ ------------
Loss from operations (1,193,604) (2,534,084) (3,092,681) (4,206,205)
------------ ------------ ------------ ------------
Other income (expense), net (603,523) (1,098,722) (771,301) (1,944,484)
Income tax expense (559,000) -- (877,000) --
------------ ------------ ------------ ------------
Net loss (2,356,127) (3,632,806) (4,740,982) (6,150,689)
Dividends on redeemable preferred stock -- (149,589) -- (297,534)
Accretion of redeemable preferred stock
to redemption amount (654,392) (7,835) (1,308,784) (15,666)
------------ ------------ ------------ ------------
Net loss applicable to common shareholders $ (3,010,519) $ (3,790,228) $ (6,049,766) $ (6,463,889)
============ ============ ============ ============
(3) PROPERTY AND EQUIPMENT
As of June 30, 2005, property and equipment consisted of:
Computer equipment $4,439,951
Software 1,543,533
Office furniture and equipment 63,246
Leasehold improvements 615,793
----------
6,662,523
Less accumulated depreciation (4,295,811)
----------
$2,366,712
==========
For the three months ended June 30, 2005 and 2004, total depreciation expense
was $398,258 and $486,503, respectively, of which $278,008 and $449,341,
respectively, was included in cost of revenue. For the six months ended June 30,
2005 and 2004, total depreciation expense was $792,959 and $890,213,
respectively, of which $601,563 and $808,134, respectively, was included in cost
of revenue.
Included in the balance above is property and equipment under a capital lease
with a cost of $1,883,090 and accumulated depreciation and amortization of
$798,257.
14
(4) CONCENTRATION OF CREDIT RISK
We sell our products and services throughout North America, Europe, and Asia/
Pacific Rim. We perform periodic credit evaluations of our customers' financial
condition and generally do not require collateral. Credit losses have been
within our expectations. For the three months ended June 30, 2005, aggregate
revenues from customers located in Europe or Asia amounted to $4.4 million, or
25% of total revenue, while revenues from customers located in North America
totaled $13.2 million, or 75% of total revenue. For the three months ended June
30, 2004, our revenues from customers located in Europe or Asia amounted to $0.5
million, or 25% of total revenue, while revenues from customers located in North
America totaled $1.4 million, or 75% of total revenue. For the six months ended
June 30, 2005, aggregate revenues from customers located in Europe or Asia
amounted to $7.4 million, or 31% of total revenue, while revenues from customers
located in North America totaled $16.2 million, or 69% of total revenue. For the
six months ended June 30, 2004, our revenues from customers located in Europe or
Asia amounted to $0.9 million, or 20% of total revenue, while revenues from
customers located in North America totaled $3.4 million, or 80% of total
revenue. On a pro forma basis, giving effect to the acquisitions as if they had
occurred at the beginning of the periods presented for the six months ended June
30, 2005 aggregate revenues from customers located in Europe or Asia amounted to
$7.4 million, or approximately 22% of total revenue, while revenues from
customers located in North America totaled $26.6 million, or approximately 78%
of total revenue.
For the three months ended June 30, 2005, one customer represented 12% of total
revenues. For the six months ended June 30, 2005 no one customer represented 10%
or more of total revenues or accounts receivable as of June 30, 2005.
For the three and six months ended June 30, 2004, revenues from three customers,
each exceeding 10% of total revenues, represented 23%, 18% and 15%, and 18%, 17%
and 17%, respectively.
(5) PER SHARE DATA
Basic loss per share is calculated using the net loss allocable to common
shareholders divided by the weighted average common shares outstanding during
the period. In accordance with accounting requirements for reverse mergers, the
historical loss per share of MSI prior to the MSI Acquisition has been
retroactively restated to reflect our capital structure. Due to our net loss,
shares from the assumed conversion of outstanding warrants, options, convertible
preferred stock and convertible debt have been omitted from the computations of
diluted loss per share for the three and six months ended June 30, 2005 and 2004
because the effect would be antidilutive. Shares issuable from common stock
equivalents that could potentially dilute earnings per share in the future that
were not included in the computation of loss per share because their effect was
anti-dilutive totaled approximately 10.3 million and 0.3 million at June 30,
2005 and 2004, respectively.
(6) SERIES A CONVERTIBLE PREFERRED STOCK
In connection with the MSI Acquisition, we designated 2.5 million authorized
shares of preferred stock as Series A Preferred shares and issued 2,466,971 of
such shares. Warrants are outstanding for the purchase of the remaining 33,029
Series A Preferred shares at a purchase price of $10.35 per share.
The Series A Preferred shares are convertible at any time upon written notice to
us into shares of common stock on a two-for-one basis. So long as at least
500,000 originally issued shares of Series A Preferred are outstanding, the
holders of Series A Preferred shares have the right to appoint three directors
to our Board of Directors. As a result, our Board of Directors has
15
been expanded to seven members to accommodate these three directors. On or after
August 16, 2008, the holders of at least 80% of the Series A Preferred shares
may elect to have us redeem the Series A Preferred for a price equal to the
greater of (i) the original issue price of $12.60 per share ($31.5 million in
the aggregate) plus accrued dividends, to the extent dividends are declared by
us, or (ii) the fair market value of the number of shares of common stock into
which such shares of Series A Preferred are convertible. Other material terms of
the Series A Preferred shares include a preference upon liquidation or
dissolution of our company, weighted-average anti-dilution protection and
pre-emptive rights with respect to subsequent issuances of securities by us
(subject to certain exceptions).
(7) DEBT
(A) SENIOR SECURED CONVERTIBLE NOTE
On the MSI Acquisition Date, liabilities assumed in the MSI Acquisition included
the fair value of a convertible note. This convertible note originated on May
13, 2004, when we consummated a private placement pursuant to which we issued a
secured convertible term note due May 13, 2007 in the principal amount of
$5,000,000 (the "Laurus Note"), and we issued a common stock purchase warrant
entitling the holder to purchase 443,500 shares of common stock (the "Laurus
Warrant") at $4.80 per share. The Laurus Note and the Laurus Warrant were sold
to Laurus Master Fund, Ltd. ("Laurus"), for a purchase price of $5,000,000. The
principal and unpaid interest on the Laurus Note is convertible into shares of
our common stock at a price of $3.00 per share, subject to antidilution
adjustments.
In connection with the issuance of the Laurus Note, we recorded the fair value
of the Laurus Warrant as a debt discount in the amount of approximately $1.8
million based upon the Black-Scholes option-pricing model, resulting in an
imputed interest rate of 37%. This discount is being amortized to earnings as
additional interest expense over the term of the Laurus Note. Accordingly, we
have recorded $133,460 and $273,005 of additional non-cash interest expense
relating to the amortization of the discount for the three and six months ended
June 30, 2005, respectively.
In accordance with EITF 00-19, we initially accounted for the fair value of the
Laurus Warrant as equity. As discussed below, in the fourth quarter of 2004, due
to an October 2004 change in the Laurus Note conversion terms, our authorized
and unissued shares available to settle the Laurus Warrant (after considering
all other commitments that may require the issuance of stock during the maximum
period the Laurus Warrant could remain outstanding) were determined to be
insufficient. As a result, we reassessed and reclassified the value of the
Laurus Warrant to a liability at the reassessment date. As a result of the
one-for-ten reverse stock split effected on June 9, 2005, there are now
sufficient authorized and unissued common shares to settle the Laurus Warrant.
During the three and six months ended June 30, 2005, we recorded a gain of
$48,785 and $390,280, respectively, on these contracts. The appropriateness of
the classification of the Laurus Warrant is reassessed at each balance sheet
date.
The Laurus Note provides for monthly payments of interest at a rate per annum
equal to the prime rate plus 1%, which is subject to reduction if the market
price of our common stock exceeds certain designated thresholds. However, the
rate cannot be less than 5% per annum. The Laurus Note also provides for monthly
amortization of principal, which commenced on September 1, 2004, of $45,455
(increased to approximately $159,000 per month beginning in March 2005) with the
balance payable on the maturity date. Laurus has the option to receive shares of
our common stock in lieu of debt service payments at the market price of our
common stock at the date of conversion. The Laurus Note
16
is collateralized by a security interest in all of our assets. The Laurus
Warrant entitles the holder to purchase, at any time through May 13, 2011, up to
443,500 shares of our common stock at a price of $4.80 per share, subject to
antidilution adjustments.
Pursuant to a Securities Purchase Agreement (the "Securities Purchase
Agreement") with Laurus, for so long as 25% of the original principal amount of
the Laurus Note is outstanding, we may not directly or indirectly declare or pay
any dividends without the prior written consent of Laurus. The Securities
Purchase Agreement also requires the written consent of Laurus in connection
with any liquidation, material reorganization or issuance of certain additional
indebtedness of the Company.
On October 26, 2004, we entered into an Amendment and Waiver, (the "Amendment
and Waiver") with Laurus that amended the Securities Purchase Agreement and
certain other documents (the "Loan Documents") and waived certain events of
default under certain of the Loan Documents. Pursuant to the Amendment and
Waiver, the parties agreed to reduce the "Fixed Conversion Price" set forth in
the Laurus Note from $5.00 to $3.00 per share and to amend the Master Security
Agreement to provide for a "Lockbox Deposit Account" to be maintained by us and
our subsidiaries under the Master Security Agreement. Lockbox remittances do not
automatically reduce the debt outstanding unless an event of default has
occurred. Laurus further agreed to (i) release to us approximately $3 million,
which represented all funds then remaining in a restricted account (less
outstanding accrued interest and fees); (ii) postpone until the maturity date of
the Laurus Note the monthly principal payable by us under the Laurus Note from
November 1, 2004 through February 1, 2005; (iii) waive certain events of
default, and all fees and default interest rates applicable to such events of
default; (iv) extend the time for our subsidiaries to be joined as a party to
the Master Security Agreement; (v) waive all fees and default interest arising
from our failure to pay the liquidated damages set forth in the Registration
Rights Agreement and further waive any liquidated damages due and payable to
Laurus by us.
In consideration of the waivers, we issued a seven-year warrant to Laurus to
purchase 50,000 shares of our common stock with an exercise price of $5.00 per
share. We further agreed to register under the Securities Act the resale of the
shares of common stock issuable upon exercise of the new warrant and the
additional shares of our common stock issuable to Laurus upon conversion of the
Laurus Note due to the adjustment of the Fixed Conversion Price. We valued the
additional warrant at $89,000, which represents the total liquidated damages
waived by Laurus as a result of the Amendment and Waiver. We recorded this
amount as a liability and additional interest expense during the quarter ended
December 31, 2004. In connection with the reverse stock split discussed above,
the fair value of the additional warrant was reclassified to additional paid-in
capital on June 9, 2005. On February 17, 2005, we entered into an Amendment and
Waiver (the "Second Amendment and Waiver") with Laurus. The Second Amendment and
Waiver waived certain events of default under the Registration Rights Agreement
(as amended on October 25, 2004) and the Laurus Note. Pursuant to the Second
Amendment and Waiver, Laurus agreed to waive all fees and default interest
arising from our failure to pay the liquidated damages set forth in the
Registration Rights Agreement and to waive any liquidated damages due and
payable to Laurus in connection with our failure to maintain the effectiveness
of the Registration Statement.
On February 18, 2005, we entered into a Waiver and Subordination Agreement with
Laurus (the "Laurus Subordination"). The Laurus Subordination waived our
obligation under the Securities Purchase Agreement to cause Incentra of CA to
become a party to the Master Security Agreement. Pursuant to the Laurus
Subordination, Laurus also agreed to subordinate to a lender its security
interest in the accounts receivable and other rights to payments, general
17
intangibles, equipment and inventory of Incentra of CA.
On February 18, 2005, in satisfaction of $375,000 of liquidated damages incurred
due to our failure to maintain the effectiveness of the registration statement,
we issued to Laurus an immediately exercisable seven-year warrant to purchase
362,500 shares of common stock at an exercise price of $2.60 per share (the
"Additional Warrant") and further agreed to register under the Securities Act
the resale of the shares of common stock issuable upon exercise of the
Additional Warrant. The Additional Warrant was valued at $375,000 and was
recorded as a liability on the issuance date. We amended our registration
statement on April 14, 2005 to include the shares issuable upon exercise of the
additional warrant and such registration statement was declared effective by the
Securities and Exchange Commission on April 25, 2005. For the six months ended
June 30, 2005, we expensed $375,000 for the liquidated damages, of which $75,000
was incurred in the quarter ended June 30, 2005. In connection with the reverse
stock split discussed above, the fair value of this additional warrant was
reclassified to additional paid-in capital on June 9, 2005.
During the three months ended June 30, 2005, we entered into two amendments with
Laurus to the Laurus Note pursuant to which the conversion price for $400,000 of
principal converted on or after April 28, 2005 was reduced to eighty seven
percent (87%) of the five (5) lowest closing prices of the common stock during
the twenty-two (22) trading days immediately prior to the date of such
conversion; provided, however, that such conversion price shall not be less than
$1.40. During the three months ended June 30, 2005, Laurus converted this
$400,000 under the Laurus Note into 277,339 shares of our common stock. The
conversion was deemed beneficial, and, as a result, additional interest expense
of approximately $110,000 was recorded during the three months ended June 30,
2005.
(B) CAPITAL LEASES
On November 20, 2003, we entered into a capital lease line of credit agreement
(the "Lease Line") for $1,500,000 with a third-party lender. The term of the
agreement is for term leases ranging from 12 to 18 months. The interest rate on
the Lease Line ranges from 10.514% per annum to 10.731% per annum. As of June
30, 2005, we have drawn $1,470,507 on the Lease Line and $29,493 of the Lease
Line had expired unused. The Lease Line is to be repaid in monthly principal and
interest installments, with the final payment due in October 2005. The unpaid
balance at June 30, 2005 was $71,073.
On March 2, 2005, we entered into an amendment to the Lease Line. Under this
amendment, we may draw an additional $500,000 (the "New Credit Facility") for
equipment purchases through June 30, 2005. The amendment also grants us a call
option to purchase equipment from the lessor. With respect to $2,333 of the New
Credit Facility amount that was unfunded on June 30, 2005, we were required to
pay the lessor 5% of such unfunded amount upon demand by the lessor. The term of
the agreement is for 15 months with an interest rate of 14.96% per annum, which
amount has since been paid. During the three and six months ended June 30, 2005,
we drew $333,490 and $497,667 on the New Credit Facility. The New Credit
Facility is to be repaid in monthly principal and interest installments through
September 2006. The unpaid balance at June 30, 2005 was $443,649.
(C) REVOLVING LINE OF CREDIT
On February 18, 2005, Incentra of CA obtained a revolving line of credit from
18
a bank, that provides for borrowings, from time to time until March 1, 2007, of
up to $5,000,000. In connection with the line of credit, on February 18, 2005,
Incentra of CA entered into a credit agreement (the "Credit Agreement") with the
bank and executed in favor of the bank a revolving line of credit note (the "LOC
Note"), a continuing security agreement (rights to payment and inventory)
("Security Agreement #1") and a security agreement (equipment) ("Security
Agreement #2, and collectively with Security Agreement #1, the "Security
Agreements"). The Credit Agreement, the LOC Note and the Security Agreements are
collectively referred to as the "Loan Documents." On March 30, 2005, the Credit
Agreement was amended to make PWI a co-borrower thereunder.
Pursuant to the Credit Agreement, the maximum principal amount of all borrowings
under the line of credit cannot exceed 80% of Incentra of CA's and PWI's
eligible accounts receivable. At certain times during the quarter ended June 30,
2005, we were over advanced on our line of credit due to fluctuations in the
eligible accounts receivable. The bank did not require the over advances to be
repaid. At June 30, 2005, we were not in an over advanced position. The Credit
Agreement further provides that all borrowed amounts shall, at the option of the
bank and without notice, become immediately due and payable upon the occurrence
of an event of default (as defined in the Credit Agreement). Principal amounts
not paid when due bear interest at 4% above the per annum rate of interest of
the LOC Note.
The LOC Note provides that interest on all outstanding principal amounts shall
accrue at a rate per annum equal to the prime rate plus 1.5%. Interest on the
LOC Note is payable monthly on the first day of each month during the term of
the LOC Note, commencing April 1, 2005. Pursuant to the Security Agreements,
borrowings under the line of credit are secured by a first priority lien on all
assets of Incentra of CA and PWI. If an event of default occurs under the
Security Agreements or the LOC Note, the bank has the right to accelerate
payments under the LOC Note and, in addition to any other remedies available to
it, to foreclose upon the assets securing the LOC Note. In addition, the LOC
Note contains certain financial covenants for which compliance is measured
quarterly. During the three and six months ended June 30, 2005, we drew $862,000
and $4,381,452 on the line of credit. We were not in compliance with one of our
covenants for the quarter ended June 30, 2005 and obtained from the bank a
waiver for this covenant through September 30, 2005.
The LOC Note was repaid in full on July 5, 2005 in connection with the New
Laurus Financing, discussed below.
(8) SUBSEQUENT EVENTS
(A) NEW LAURUS FINANCING
On June 30, 2005, we entered into a Security Agreement with Laurus pursuant to
which Laurus provided us with a $9 million revolving, convertible credit
facility (the "Facility"). The term of the Facility is three years. In
connection with the Facility, we executed in favor of Laurus a $9 million
Secured Revolving Note (the "Revolver Note"). Borrowings under the Facility
accrue interest at a rate per annum equal to the "prime rate" (as published in
The Wall Street Journal) plus 1%, which is subject to reduction if the market
price of our common stock exceeds certain designated thresholds. Pursuant to the
Facility, the minimum initial amount available to us, until December 31, 2005,
is $6.0 million. Thereafter, the maximum principal amount of all borrowings
under the Facility cannot exceed 90% of the combined eligible accounts
receivable of PWI and Incentra of CA.
Pursuant to the revolver note issued under the Facility, Laurus has the option
to convert borrowings under the Facility into shares of our common
19
stock. The first $3 million of borrowings are convertible into shares of our
common stock registered under the Securities Act of 1933, as amended (the
"Act"), at a fixed conversion price of $2.05 (as adjusted for dilutive
issuances, stock splits, stock dividends and the like, "as adjusted"). The
second $3 million of borrowings are convertible into unregistered shares of our
common stock at a fixed conversion price of $2.56, as adjusted. The last $3
million of borrowings are convertible into unregistered shares of our common
stock at a fixed conversion price of $2.99, as adjusted.
On July 5, 2005, we requested, and Laurus agreed to lend, an initial draw under
the Facility of $6.0 million, of which approximately $4.4 million was used to
extinguish, in full, our indebtedness to Wells Fargo Bank, N.A. and the balance
of the initial draw, less expenses of the Facility, will be used for general
corporate and working capital purposes.
Borrowings under the Facility are collateralized by a security interest in
substantially all of our assets, including a pledge to Laurus of all of the
outstanding capital stock of PWI and Incentra of CA. Repayment of borrowings
under the Facility is guaranteed by PWI and Incentra of CA pursuant to a
Subsidiary Guaranty in favor of Laurus.
In connection with the financing, we issued Laurus a warrant that entitles
Laurus to purchase, at any time through June 30, 2012, up to 400,000 shares of
our common stock at a price of $2.63 per share, as adjusted (the "Warrant").
The first $3 million of borrowings under the Facility is further evidenced by a
Secured Convertible Minimum Borrowing Note (the "$3 Million Minimum Borrowing
Note"), which provides Laurus with certain additional rights, including without
limitation, the right to receive a pre-payment penalty and certain registration
rights (as further described herein). In the event we redeem, or prepay, the
outstanding balance under the $3 Million Minimum Borrowing Note, we are required
to pay Laurus a sum equal to one hundred twenty five percent (125%) of the
principal amount outstanding under such note, together with accrued but unpaid
interest thereon. All other borrowings under the Facility may be prepaid from
time to time without penalty.
Pursuant to a registration rights agreement with Laurus, we are obligated to:
(a) file a registration statement under the Act to register the resale of the
shares of our common stock issuable upon conversion of the $3 Million Minimum
Borrowing Note and exercise of the Warrant (the "Registration Statement") within
55 days of the date of the funding with respect to the $3 Million Minimum
Borrowing Note; (b) use our best efforts to have the Registration Statement
declared effective under the Act as promptly as possible, but in any event prior
to the 115th day following the funding of the $3 Million Minimum Borrowing Note;
and (c) maintain the effectiveness of the Registration Statement until the
earliest date of when (i) all registrable securities have been sold, (ii) all
registrable securities may be sold immediately without registration under the
Act and without volume restrictions pursuant to Rule 144(k) or (iii) all amounts
payable under the $3 Million Minimum Borrowing Note have been paid in full.
Laurus is entitled to certain remedies specified in the registration rights
agreement if we do not timely comply with its registration obligations.
In connection with the Facility, we paid Laurus approximately $359,000,
comprised of a facility fee of $324,000 (representing an annual fee equal to
1.2% of the Facility payable in advance at closing) and reimbursement of $35,000
of Laurus' expenses.
20
Concurrently with the closing of the Facility, we amended our existing Secured
Convertible Term Note with Laurus, dated March 13, 2004, to provide that an
event of default by us under the Facility shall also constitute an event of
default under such Term Note.
On August 1, 2005, we entered into an amendment with Laurus to the Laurus Note
pursuant to which the conversion price for $200,000 of principal converted on or
after April 28, 2005 was reduced to an amount equal to eighty seven percent
(87%) of the average of the five (5) lowest closing prices of the common stock
during the twenty-two (22) trading days immediately prior to the date of such
conversion, but not less than $1.52. On August 1, 2005, Laurus converted this
$200,000 into 131,579 shares of our common stock. The conversion was deemed
beneficial, and as a result, additional interest expense of approximately
$40,000 will be recorded during the three months ended September 30, 2005.
As of August 11, 2005, the default on the STAR Note discussed in footnote 2(A)
above and item (B) below, created an event of default of certain provisions of
the Facility and the Term Note discussed in footnote 7(A). On August 12, 2005,
we obtained a waiver from Laurus waiving the default.
(B) STAR Note Default
We elected not to make the August 1, 2005 payment within the grace period
allowed under the STAR Note, which creates an event of default as of August 11,
2005. We have not received any notice of default or acceleration from the STAR
note holder. We elected not to make the scheduled payment as we are in the
process of negotiating post-closing adjustments to the purchase, which could
have a significant impact on the amount and terms of the note. As of the balance
sheet date, we have reclassified approximately $1.3 million of the debt to
current liabilities based on the default. Management does not believe the debt
will be paid in one year from the balance sheet date, however, the
reclassification on the balance sheet was made as the debt is now callable.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
GENERAL
When used in this discussion, the word "believes", "anticipates", "expects" and
similar expressions are intended to identify forward-looking statements. Such
statements are subject to certain risks and uncertainties that could cause
actual results to differ materially from those projected.
Our business and results of operations are affected by a wide variety of factors
that could materially and adversely affect us and our actual results, including,
but not limited to: (1) the availability of additional funds to enable us to
successfully pursue our business plan; (2) the uncertainties related to the
effectiveness of our technologies and the development of the our products and
services; (3) our ability to maintain, attract and integrate management
personnel; (4) our ability to complete the development and continued enhancement
of our products in a timely manner; (5) our ability to effectively market and
sell our products and services to current and new customers; (6) our ability to
negotiate and maintain suitable strategic partnerships, vendor relationships and
corporate relationships; (7) the intensity of competition; and (8) general
economic conditions. As a result of these and other factors, we may experience
material fluctuations in future operating results on a quarterly or annual
basis, which could materially and adversely affect our business, financial
condition, operating results and stock price.
Any forward-looking statements herein speak only as of the date hereof. We
undertake no obligation to publicly release the results of any revisions to
these forward-looking statements that may be made to reflect events or
circumstances after the date hereof or to reflect the occurrence of
unanticipated events.
OVERVIEW
We are a supplier of complete solutions for an enterprise's data protection
needs. We supply a broad range of storage products and storage management
services to broadcasters, enterprises and information technology service
providers worldwide. We market our products and services to broadcasters under
the trade name Front Porch Digital ("Front Porch") and to service providers and
enterprise clients under the trade names ManagedStorage International ("MSI"),
Incentra Solutions ("Incentra of CA") and PWI Technologies ("PWI"). Front Porch
provides unique software and professional services solutions for digital archive
management to broadcasters and media
21
companies. MSI provides outsourced storage solutions, including engineering,
hardware and software procurement and remote storage operations services.
Incentra of CA and PWI are leading systems integrators that provide Information
Technology ("IT") products, professional services and outsourcing solutions to
enterprise customers located primarily in the western United States.
Through Front Porch, we provide a software and management solution that enables
searching, browsing, editing, storage and on-demand delivery of media-rich
content in nearly any digital format. The software converts audio, video,
images, text and data into digital formats for ease of use and archiving. With
more than 100 installations worldwide, our DIVArchive software has become a
leading digital archive management application among European and Asian
broadcast and media companies, and is gaining an increasing share of the North
American market. Front Porch's DIVArchive and BitScream applications provide the
essential integration layer within the digital content creation and broadcast
environments. Front Porch built its archive management and transcoding
software-based solutions on intelligent, distributed architecture, which makes
than flexible, scalable, easily upgradable, failure resilient and
well-integratable with leading automation and asset management applications.
Through MSI, we deliver comprehensive storage services including professional
services, hardware/software procurement and resale, financing solutions and
remote monitoring/management services. We focus on providing data protection
solutions and services that ensure that our customers' data is backed-up and
recoverable and meets internal data retention compliance policies. MSI's remote
monitoring and management services are delivered from its Storage Network
Operations Center, which monitors and manages a multitude of diverse storage
infrastructures on a 24x7 basis throughout the United States, United Kingdom,
Bermuda and Tokyo. MSI delivers this worldwide service utilizing its proprietary
GridWorks Operations Support System, which enables automated remote monitoring
and management of complete storage infrastructures and back-up applications. MSI
provides outsourcing solutions for customer data protection needs under
long-term contracts. Customers pay on a monthly basis for storage services based
on the number of assets managed and/or the volume of storage assets utilized.
These customers benefit from reduced operating costs and reductions in capital
expenditures.
Through Incentra of CA and PWI, we deliver complete IT solutions, including
professional services, third-party hardware/software procurement and resale,
financing solutions and the sale and delivery of first call support for
third-party hardware and software maintenance (including help desk operations).
Solutions are sold primarily to enterprise customers in the financial services,
government, hospitality, retail, security, healthcare and manufacturing sectors.
With offices and sales personnel located primarily throughout the western United
States, these recently acquired entities are a cornerstone to its North American
expansion plans.
The following discussion and analysis of financial condition and results of
operations is based upon our pro forma and historical consolidated financial
statements, which have been prepared in accordance with accounting principles
generally accepted in the United States of America. The preparation of these
consolidated financial statements requires management to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and
expenses, and related disclosure of contingent assets and liabilities. These
estimates are based on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ from these estimates under different assumptions or conditions.
22
BUSINESS OUTLOOK
The following summarized discussion of financial results for the three and six
months ended June 30, 2005 and 2004 is of our results on a pro forma basis,
giving effect to the acquisitions referred to in Note 2 above as if they had
occurred at the beginning of all periods presented. We believe the pro forma
results of operations provide additional and more relevant information about the
operating performance of our business and give a better indication of our
results of operations, and the size and scalability of our business on a forward
looking basis. However, the pro forma statements are not intended as a
substitute for financial statements prepared in accordance with generally
accepted accounting principles.
For the three and six months ended June 30, 2005, pro forma revenues totaled
$17.6 million and $34.0 million, respectively, as compared to $13.9 million and
$28.1 million for the comparable prior periods. The rate of year-over-year
growth in revenues for the three and six months ended 2005 was approximately 27%
and 21%, respectively. The significant growth in revenue was a result of
increased sales and deliveries of our proprietary DIVArchive solution,
third-party hardware and software and our professional services. In addition, we
have a recurring revenue base created by our proprietary Gridworks Operations
System Support solution that provides added stability and predictability in
revenue, as well as a significant growth opportunity through the expansion of
services to existing customers, the continued increase in the amount of data
under protection, as well as new enterprise and service provider customer
opportunities.
We continue to invest in hardware and the development of our software and
digital archiving in the data storage and infrastructure areas. During the six
months ended June 30, 2005, we invested $0.7 million in software development and
$0.4 million for data storage infrastructure development.
During the three months ended June 30, 2005, our pro forma loss from operations
decreased by approximately $1.3 million, to $1.2 million as compared to a pro
forma loss of $2.5 million for the comparable prior year period. This reduction
in our pro forma loss was due to $0.7 million of increased gross margins as a
result of our increased revenues, decreased general and administrative costs of
$0.4 million and the elimination of a $0.1 million impairment loss recorded in
2004. The improvement in our general and administrative expenses was due to the
absence of owner-related costs in our 2005 acquisitions and the decrease in
MSI's expenses as a result of reduced staffing levels.
During the three and six months ended June 30, 2005, we realized an adjusted
EBITDA(1) profit of approximately $0.3 million and $0.7 million, respectively,
- --------------------------
(1) EBITDA is defined as earnings before interest, taxes, depreciation and
amortization and cumulative effect of changes in accounting principles. Although
EBITDA is not a measure of performance or liquidity calculated in accordance
with generally accepted accounting principles (GAAP), we believe the use of the
non-GAAP financial measure EBITDA enhances an overall understanding of our past
financial performance and is a widely-used measure of operating performance in
practice. In addition, we believe the use of EBITDA provides useful information
to the investor because EBITDA excludes significant non-cash interest and
amortization charges related to past financings by us and amortization of
intellectual property acquired in the acquisitions, that, when excluded, we
believe produces more meaningful operating information. EBITDA also excludes
depreciation and amortization expenses. However, investors should not consider
this measure in isolation or as a substitute for net income, operating income,
cash flows from operating activities or any other measure for determining our
operating performance or liquidity that are calculated in accordance with GAAP,
and this measure may not necessarily be comparable to similarly titled measures
employed by other companies. A reconciliation of EBITDA to the most comparable
GAAP financial measure on a pro forma basis, net loss before deemed dividends
and accretion on preferred stock is set forth below.
* EBITDA Reconciliation
June 30, 2005
All amounts in (000's)
Three Months Six Months
Ended Ended
2005 2005
---- ----
Pro forma net loss before deemed dividends and
accretion on preferred stock $(2,356) $(4,741)
Depreciation and amortization 1,347 2,694
Taxes 559 879
Interest (cash portion) 171 326
Interest (non-cash portion) 436 897
------- -------
EBITDA 157 55
------- -------
Former owner costs -- 314
Non-cash stock based compensation 108 264
Referral fees 29 72
------- -------
EBITDA, as adjusted $ 294 $ 705
======= =======
23
on a pro forma basis. EBITDA adjustments remove the impacts of the former
owner's costs as well as non-cash stock compensation expense and referral fee
amortization. Also included in EBITDA for the three and six months ended June
30, 2005 was a gain of approximately $49,000 and $390,000, respectively, due to
the revaluation of the derivative warrant liability. During the three months
ended June 30, 2005, we received an insurance settlement of $0.1 million from a
customer theft of equipment. This was accounted for as a purchase price
adjustment. However, if this cash settlement were recorded in the period, it
would result in $0.4 million in adjusted EBITDA for the period.
We intend to further leverage our unique intellectual property by continuing to
leverage our position as a leading provider of archive software solutions. In
addition, we intend to expand our product and service offerings to position
ourselves as a provider of a wide range of services and products to the
broadcast and media markets. We believe we can increase revenues from existing
and new customers by offering complete archive solutions, including storage
hardware and software, servers and peripheral devices, as well as first call
support services. To facilitate this strategy, we intend to increase our volume
of products available for resale to customers both directly and through existing
channel partners. We also plan to increase our expenditures for sales and
marketing initiatives to meet what appears to be an increasing volume of digital
archive implementations in the North American market and throughout the rest of
the world.
We also believe we can increase our sales of managed services by introducing
these services to the customers of our recently acquired businesses. We believe
professional services will also be enhanced as we leverage our engineering
resources across our entire customer base. In the three months ended June 30,
2005, we increased engineering and sales resources and will continue to increase
these resources, which are focused on the enterprise market and will resell a
variety of storage products directly to businesses.
As we continue to grow, we will need to sustain and possibly increase the
investment of capital into our software technologies, Gridworks and DIVArchive,
to ensure they maintain their competitive advantage and to further enhance their
inter-operability and feature sets.
RESULTS OF OPERATIONS - THREE MONTHS ENDED JUNE 30, 2005 COMPARED TO THE
THREE MONTHS ENDED JUNE 30, 2004
24
REVENUE. Total revenue for the three months ended June 30, 2005 increased
$15.7 million, or 827%, to $17.6 million compared to total revenue of $1.9
million for the three months ended June 30, 2004. Revenue from the sale of our
products increased to $13.8 million compared to revenue of approximately $30,000
for the comparable prior year period. This increase was attributable to the
additional revenues of $13.7 resulting from the acquisitions of Front Porch,
Incentra of CA and PWI. Revenue from delivery of our services increased $1.9
million, or 100%, to $3.8 million compared to $1.9 million for the comparable
prior year period. Service revenue increased $1.9 million due to the
acquisitions as described above.
For the quarter ended June 30, 2005, a significant portion of our
revenues were derived from the European and Asian geographic markets. During
that period, aggregate revenues from customers located in Europe or Asia
amounted to $4.4 million, or 25% of total revenue, while revenues from customers
located in North America totaled $13.2 million, or 75% of total revenue. For the
quarter ended June 30, 2004, revenues from customers located in Europe and Asia
amounted to $1.0 million, or 55% of total revenue, while revenues from customers
located in North America totaled $0.9 million, or 45% of total revenue.
GROSS MARGIN. Total gross margin for the three months ended June 30,
2005 increased $4.5 million to $5.1 million, or 29% of total revenue, as
compared to gross margin of $0.6 million, or 30% of total revenue, for the
comparable prior year period. Product gross margin for the three months ended
June 30, 2005 totaled $3.8 million, or 27% of product revenue. Service gross
margin for the three months ended June 30, 2005 totaled $1.3 million, or 35% of
service revenue. Gross margins were consistent with management expectations for
the quarter.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative ("SG&A") expenses for the three months ended June 30, 2005
increased by approximately $3.3 million to $5.4 million from $2.1 million for
the comparable prior year period. SG&A expenses included $3.6 million in
salaries and related benefits for employees not directly related to the
production of revenue, $0.7 million in general office expenses, $0.4 million in
professional fees, $0.3 million for travel-related costs, and $0.3 million in
facilities costs. SG&A expenses of $2.1 million for the comparable prior year
period included $1.3 million in salaries and related benefits for employees not
directly related to the production of revenue, $0.3 million in general office
expenses, $0.1 million in travel related costs, $0.2 million in professional
fees, $0.1 million of facilities costs and $0.1 million of bad debt expense. The
increase in SG&A expenses during the three months ended June 30, 2005 was due to
the inclusion of $3.9 million of SG&A expenses for the acquisitions described
above, offset by a reduction in MSI's SG&A expenses.
DEPRECIATION AND AMORTIZATION. Amortization expense consists of
amortization of intellectual property, capitalized research and development
costs and other intangible assets. Depreciation expense consists of depreciation
of furniture, equipment, software and improvements. Depreciation and
amortization expense was approximately $1.3 million and $0.8 million for the
three months ended June 30, 2005 and 2004, respectively, of which $0.3 million
and $0.4 million was included in cost of revenue for the periods ending June 30,
2005 and 2004. The increase was primarily due to the increase in amortization
associated with the intangible assets created in the acquisition of Front Porch.
OPERATING LOSS. During the three months ended June 30, 2005, we incurred
a loss from operations of $1.2 million as compared to a loss from operations of
$1.9 million for the three months ended June 30, 2004. This
25
decrease in operating loss was primarily the result of an increase in gross
margin of approximately $4.5 million for the three months ended June 30, 2005
offset by an increase in selling, general and administrative expenses of
approximately $3.3 million and depreciation expense of $0.6 million due to the
acquisitions of Front Porch, Incentra of CA and PWI.
INTEREST EXPENSE. Interest expense was $0.6 million for the three months
ended June 30, 2005 compared to $0.7 million for the three months ended June 30,
2004. The decrease in interest expense was attributable to a decrease of $0.7
million of non-cash interest expense on MSI's previously outstanding Series C
preferred stock, offset in part, by an increase in non-cash interest of $0.1
million related to warrants, non-cash interest of $0.4 million for amortization
of debt discounts and deferred financing costs and $0.2 million of cash interest
on senior secured convertible notes and capital leases.
OTHER INCOME AND EXPENSE. Other income was approximately $11,000 for the
three months ended June 30, 2005 compared to approximately $34,000 for the three
months ended June 30, 2004. Other income for the three months ended June 30,
2005 and 2004 included investment income from leased equipment to customers and
gains from sales of fixed assets and the revaluation of our derivative warrant
liability.
FOREIGN CURRENCY TRANSACTION GAIN (LOSS). As discussed above, we conduct
business in various countries outside the United States in which the functional
currency of the country is not the U. S. dollar. We are subject to foreign
exchange transaction exposure because we provide for intercompany funding
between the U.S. and international operations, when we and/or our French
subsidiary transact business in a currency other than our own functional
currency. The effects of exchange rate fluctuations in remeasuring foreign
currency transactions for the three months ended June 30, 2005 resulted in a
loss of approximately $8,000
INCOME TAX EXPENSE. We incurred income tax expense for the three months
ended June 30, 2005 of $0.6 million. This expense represented non-cash income
tax expense related to our French subsidiary, Front Porch Digital International,
SAS. These income taxes have no cash impact due to the utilization of the
subsidiary's deferred tax assets during the period.
NET LOSS APPLICABLE TO COMMON SHAREHOLDERS. During the three months
ended June 30, 2005, we incurred a net loss applicable to common shareholders of
$3.0 million as compared to a net loss applicable to common shareholders of $2.7
million for the three months ended June 30, 2004. The increase in net loss for
the three months ended June 30, 2005 was primarily due to an increase in
accretion on the outstanding Series A preferred stock of $0.7 million.
RESULTS OF OPERATIONS - SIX MONTHS ENDED JUNE 30, 2005 COMPARED TO THE
SIX MONTHS ENDED JUNE 30, 2004
REVENUE. Total revenue for the six months ended June 30, 2005 increased
$19.3 million, or 449%, to $23.6 million compared to total revenue of $4.3
million for the six months ended June 30, 2004. Revenue from the sale of our
products increased to $17.0 million compared to revenue of $0.4 million for the
comparable prior year period. Revenue from product sales increased $16.6 million
from $0.4 million to $17.0 million for the comparable prior year period. Front
Porch, Incentra of CA and PWI contributed $16.9 million of the increase, offset
slightly by a decline in MSI product revenue of $0.3 million. Revenue from
delivery of our services increased $2.7 million, or 71%, to $6.6 million
compared to $3.9 million for the comparable prior year period. Service revenue
increased $2.7 million due to the acquisitions of Front Porch, Incentra of CA,
and PWI.
26
For the six months ended June 30, 2005, a significant portion of our
revenues were derived from the European and Asian geographic markets. During
that period, aggregate revenues from customers located in Europe or Asia
amounted to $7.4 million, or 31% of total revenue, while revenues from customers
located in North America totaled $16.2 million, or 69% of total revenue. For the
six months ended June 30, 2004, revenues from customers located in Europe and
Asia amounted to $0.9 million, or 20% of total revenue, while revenues from
customers located in North America totaled $3.4 million, or 80% of total
revenue.
GROSS MARGIN. Total gross margin for the six months ended June 30, 2005
increased $6.3 million to $8.0 million, or 34% of total revenue, as compared to
gross margin of $1.7 million, or 40% of total revenue, for the comparable prior
year period. Product gross margin for the six months ended June 30, 2005 totaled
$5.7 million, or 34% of product revenue. Service gross margin for the six months
ended June 30, 2005 totaled $2.3 million, or 35% of service revenue. The
decrease in gross margin was the result of lower gross margins on third party
products, offset by increased gross margins realized by Front Porch on sales of
its DIVArchive.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative ("SG&A") expenses for the six months ended June 30, 2005
increased by approximately $5.3 million to $9.4 million from $4.1 million for
the comparable prior year period. SG&A expenses for the six months ended June
30, 2005 included $6.2 million in salaries and related benefits for employees
not directly related to the production of revenue, $1.1 million in general
office expenses, $0.9 million in professional fees, $0.6 million for
travel-related costs, $0.5 million in facilities costs and $0.1 million in
research and development costs. SG&A expenses of $4.1 million for the comparable
prior year period included $2.5 million in salaries and related benefits for
employees not directly related to the production of revenue, $0.7 million in
general office expenses, $0.3 million in travel related costs, $0.3 million in
professional fees, $0.2 million of facilities costs and $0.1 million of bad debt
expense. The increase in SG&A expenses during the six months ended June 30, 2005
was due to the inclusion of $6.3 million of SG&A expenses for Front Porch,
Incentra of CA and PWI for the full quarter. This increase was offset by $1.0
million of reduced SG&A expenses at MSI, primarily as a result of decreased
staffing levels, and in general office expenses.
DEPRECIATION AND AMORTIZATION. Amortization expense consists of
amortization of intellectual property, capitalized research and development
costs and other intangible assets. Depreciation expense consists of depreciation
of furniture, equipment, software and improvements. Depreciation and
amortization expense was approximately $2.6 million and $1.5 million for the six
months ended June 30, 2005 and 2004, respectively, of which $0.6 million and
$0.8 million was included in cost of revenue for the periods ended June 30, 2005
and 2004. The increase was primarily due to the increase in amortization
associated with the intangible assets created in the acquisition of Front Porch.
OPERATING LOSS. During each of the six months ended June 30, 2005 and
June 30, 2004, we incurred a loss from operations of $3.1 million. An increase
in gross margin of approximately $6.3 million for the six months ended June 30,
2005 offset by an increase in selling, general and administrative expenses of
approximately $6.3 million during the period related to the acquisitions.
INTEREST EXPENSE. Interest expense was $1.2 million for the six months
ended June 30, 2005 compared to $1.4 million for the six months ended
27
June 30, 2004. The decrease in interest expense was attributable to a decrease
of $1.3 million of non-cash interest expense on MSI's previously outstanding
Series C preferred stock, offset in part, by an increase in non-cash interest of
$0.3 million related to warrants, non-cash interest of $0.5 million for
amortization of debt discounts and deferred financing costs, $0.1 million
related to the conversion of debt to equity and $0.3 million of cash interest on
senior secured convertible notes and capital leases.
OTHER INCOME AND EXPENSE. Other income was $0.4 million for the six
months ended June 30, 2005 compared to $0.1 million for the six months ended
June 30, 2004. Other income of $0.4 million for 2005 included $0.3 million of
income resulting from the revaluation of our derivative warrant liability and
$0.1 million of investment income from leased equipment to customers and gains
from sales of fixed assets.
FOREIGN CURRENCY TRANSACTION GAIN. As discussed above, we conduct
business in various countries outside the United States in which the functional
currency of the country is not the U. S. dollar. We are subject to foreign
exchange transaction exposure because we provide for intercompany funding
between the U.S. and international operations, when we and/or our French
subsidiary transact business in a currency other than our own functional
currency. The effects of exchange rate fluctuations in remeasuring foreign
currency transactions for the six months ended June 30, 2005 resulted in a loss
of approximately $1,000. In addition, we entered into a forward contract, which
expired on April 1, 2005, for which we recorded a realized gain of approximately
$74,600 for the six months ended June 30, 2005, which represented the change in
the fair value for the foreign currency forward contract related to the
difference between changes in the spot and forward rates excluded from the
assessment of hedge effectiveness.
INCOME TAX EXPENSE. We incurred income tax expense for the six months
ended June 30, 2005 of $0.9 million. This income tax expense represents non-cash
income tax expense related to our French subsidiary, Front Porch Digital
International, SAS. These income taxes have no cash impact due to the
utilization of the subsidiary's deferred tax assets (net operating losses)
during that period.
NET LOSS APPLICABLE TO COMMON SHAREHOLDERS. During the six months ended
June 30, 2005, we incurred a net loss applicable to common shareholders of $6.0
million as compared to a net loss applicable to common shareholders of $4.8
million for the six months ended June 30, 2004. The increase in net loss for the
six months ended June 30, 2005 was primarily due to an increase in accretion on
the outstanding Series A preferred stock of $1.3 million.
LIQUIDITY AND CAPITAL RESOURCES
At June 30, 2005, we had $2.1 million of cash and cash equivalents. At June 30,
2005, we had a working capital deficit of $3.8 million of which $1.3 million of
the deficit is attributable to the reclassification of the STAR Note to current
liabilities due to the default on the STAR Note described in footnote 8(B) in
the notes to unaudited condensed consolidated financial statements. We used net
cash of $1.1 million in operating activities during the six months ended June
30, 2005, primarily as a result of the net loss incurred during the period. We
provided net cash of $0.4 million in investing activities during the six months
ended June 30, 2005, of which $1.7 million represented cash acquired from the
acquisitions, which was offset by $1.2 million used primarily to purchase or
develop computer software and equipment. Financing activities used net cash of
$0.2 million during the six months ended June 30, 2005 primarily from the
repayment of capital leases, long-term obligations and notes payable of $1.6
million, which was offset by proceeds of $1.4 million from a lease line of
credit and our revolving line of credit.
We expect our anticipated cash flow from operations combined with our current
cash and cash equivalents will meet our working capital and capital expenditure
requirements for at least the next twelve months. We believe we
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have sufficient capital available for the execution of our business strategy and
our continued growth and expansion. However, there can be no assurance that we
will not need to access the capital markets for additional financing to fund our
organic growth or subsequent acquisitions and that sufficient capital will be
available upon acceptable terms. We expect capital expenditures to be
approximately $2.6 million during the 12-month period ended June 30, 2006.
Capital expenditures are comprised of approximately $1.0 million of capital
equipment purchase and $1.6 million of capitalized development costs for our
internally developed software platforms. The amount of spending in each
respective area is dependent upon the total capital available to us.
Our actual financial results may differ materially from the stated plan of
operations. Factors which may cause a change from our plans of operation vary,
but include, without limitation, decisions of our management and board of
directors not to pursue the stated plan of operations based on its reassessment
of the plan and general economic conditions. Additionally, there can be no
assurance that our business will generate cash flows at or above current levels.
Accordingly, we may choose to defer capital expenditure plans and extend vendor
payments for additional cash flow flexibility.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 123(R), SHARE-BASED PAYMENT, which addresses the accounting for share-based
compensation transactions. SFAS No. 123(R) eliminates the ability to account for
share-based compensation transactions using APB 25, and generally requires
instead that such transactions be accounted and recognized in the statement of
operations based on their fair value. SFAS No. 123(R) will be effective for
public companies that file as small business issuers as of the first interim or
annual reporting period that begins after December 15, 2005. We are currently
evaluating the provisions of this standard. However, we expect that the
implementation of this standard will have a material impact on our financial
position and results of operations.
In May 2005, the FASB issued SFAS No. 154, ACCOUNTING CHANGES AND ERROR
CORRECTIONS, which changes the requirements for the accounting and reporting of
a change in accounting principle and applies to all voluntary changes in
accounting principle. It also applies to changes required by an accounting
pronouncement in the unusual instance that the pronouncement does not include
specific transition provisions. When a pronouncement includes specific
transition provisions, those provisions should be followed. APB No. 20 required
that most voluntary changes in accounting principle be recognized by including
in net income of the period of the change the cumulative effect of changing to
the new accounting principle. This statement requires retrospective application
to prior period financial statements of changes in accounting principle, unless
it is impracticable to determine either the period-specific effects or the
cumulative effect of the change. The provisions of SFAS No. 154 are effective
for fiscal years beginning after December 15, 2005. We do not expect this
statement to have a material impact on our on our financial position or results
of operations.
ITEM 3. CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES. Our management, with the participation of
our chief executive officer and chief financial officer, has evaluated the
effectiveness of our disclosure controls and procedures (as such term is defined
in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended (the "Exchange Act")) as of the end of the period covered by this
report. Based on such evaluation, our chief executive officer and chief
financial officer have concluded that, as of the end of such period, our
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disclosure controls and procedures are effective in recording, processing,
summarizing and reporting, on a timely basis, information required to be
disclosed by us in the reports that it files or submits under the Exchange Act.
INTERNAL CONTROL OVER FINANCIAL REPORTING. There have not been any changes in
our internal control over financial reporting (as such term is defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act) during the first quarter of 2005
that have materially affected, or are reasonably likely to materially affect,
our internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS:
On June 30, 2005, in connection with the credit facility from Laurus Master Fund
Ltd. ("Laurus") described herein, we issued to Laurus a secured convertible
promissory note in the amount of $9.0 million, of which the first $3.0 million
of borrowings are convertible into shares of our common stock registered under
the Securities Act of 1933, as amended, at a fixed conversion price of $2.05 (as
adjusted for dilutive issuances, stock splits, stock dividends and the like "as
adjusted"), the second $3.0 million of borrowings is convertible into shares of
unregistered common stock at a fixed conversion price of $2.56; and a secured
convertible note in the amount of $3.0 million, which is convertible into shares
of unregistered common stock at a fixed conversion price of $2.99. The funding
of the secured convertible promissory note occurred on July 5, 2005 when we
advanced $6.0 million on this facility.
The convertible notes issued by us in the transaction was issued in reliance on
the exemption from registration provided by Section 4(2) of the Securities Act
of 1933, as amended, on the basis that such issuance did not involve a public
offering, no underwriter fees or commissions were paid in connection with such
issuance and Laurus represented to us that it was `accredited investors' as
defined in Regulation D under the Securities Act of 1933, as amended.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
On April, 1, 2005, stockholders beneficially owning an aggregate of
approximately 9.0 million shares of our common stock, representing approximately
52% of the voting power of our company, delivered their written consent to amend
the Company's 2000 Equity Incentive Plan (the "Plan") to increase the maximum
number of shares of our common stock available for issuance thereunder from
6,000,000 shares to 22,625,000 shares. As a result of the one-for-ten reverse
stock split described above, the authorized shares in the Plan have been reduced
to 2,262,500 shares.
On April 12, 2005, stockholders beneficially owning an aggregate of
approximately 10.7 million shares of our common stock, representing
approximately 61% of the voting power of our company, delivered their written
consent to adopt a resolution to amend our Articles of Incorporation to effect a
stock combination, or reverse stock split, pursuant to which every ten shares of
the our outstanding common stock would be exchanged for one new share of common
stock.
ITEM 6. EXHIBITS.
The exhibits required by this item are listed on the Exhibit Index attached
hereto.
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SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant
has caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
Dated: August 15, 2005 INCENTRA SOLUTIONS, INC.
By: /s/ Thomas P. Sweeney III
-------------------------
Thomas P. Sweeney III
Chief Executive Officer
(principal executive officer)
By: /s/ Paul McKnight
-------------------------
Paul McKnight
Chief Financial Officer
(principal financial and
accounting officer)
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EXHIBIT INDEX
31.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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