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 March 31, 2006
[_] 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
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(State or other jurisdiction (I.R.S. Employer
of (incorporation or organization) Identification No.)
1140 PEARL STREET
BOULDER, COLORADO 80302
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(Address of principal executive offices)
(303) 449-8279
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(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 [_]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act. Yes [_] No [X]
As of May 3, 2006, 14,361,293 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]
PART I. FINANCIAL INFORMATION
INCENTRA SOLUTIONS, INC.
CONDENSED CONSOLIDATED BALANCE SHEET
(UNAUDITED)
MARCH 31
2006
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ASSETS
Current assets:
Cash and cash equivalents $ 457,183
Accounts receivable, net of allowance for doubtful accounts of $228,602 10,211,945
Other current assets 1,300,385
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Total current assets 11,969,513
Property and equipment, net 2,417,939
Capitalized software development costs, net 2,312,001
Intangible assets, net 12,946,473
Goodwill 5,857,770
Restricted cash 38,046
Other assets 519,110
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TOTAL ASSETS $ 36,060,851
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LIABILITIES AND SHAREHOLDERS' DEFICIT
Current liabilities:
Current portion of notes payable, capital leases and other long term obligations $ 10,964,731
Accounts payable 8,479,311
Accrued expenses 4,509,564
Current portion of deferred revenue 2,346,147
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Total current liabilities 26,299,753
Notes payable, capital leases and other long term obligations, net of current portion 232,079
Deferred revenue, net of current portion 98,270
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TOTAL LIABILITIES 26,630,102
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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 25,272,725
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Shareholders' deficit:
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, 13,326,810
outstanding at March 31, 2006 13,327
Additional paid-in capital 120,520,704
Accumulated other comprehensive loss (95,213)
Accumulated deficit (136,280,794)
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TOTAL SHAREHOLDERS' DEFICIT (15,841,976)
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TOTAL LIABILITIES AND SHAREHOLDERS' DEFICIT $ 36,060,851
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See accompanying notes to unaudited condensed consolidated financial statements.
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(UNAUDITED)
THREE MONTHS ENDED MARCH 31,
2006 2005
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Revenues:
Products $ 9,543,801 $ 3,231,513
Services 3,365,370 2,775,652
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TOTAL REVENUE 12,909,171 6,007,165
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Cost of revenue:
Products 5,443,048 1,276,375
Services 2,348,442 1,787,610
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Total cost of revenue 7,791,490 3,063,985
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GROSS MARGIN 5,117,681 2,943,180
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Selling, general and administrative 5,987,905 4,027,373
Amortization 644,547 785,281
Depreciation 107,376 71,143
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6,739,828 4,883,797
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LOSS FROM OPERATIONS (1,622,147) (1,940,617)
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Other income (expense):
Interest income 239 22,431
Interest expense (628,933) (561,310)
Loss on early extinguishment of debt (1,232,174) --
Other (expense) income (60,397) 366,741
Foreign currency transaction gain 1,290 82,189
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(1,919,975) (89,949)
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LOSS BEFORE INCOME TAX (3,542,122) (2,030,566)
Income tax expense (94,339) (318,000)
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NET LOSS (3,636,461) (2,348,566)
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Accretion of redeemable preferred stock to redemption amount (654,392) (654,391)
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NET LOSS APPLICABLE TO COMMON SHAREHOLDERS $ (4,290,853) $ (3,002,957)
============ ============
COMPREHENSIVE NET LOSS
Net Loss $ (3,636,461) $ (2,348,566)
Foreign currency translation adjustments 8,022 (77,233)
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$ (3,628,439) $ (2,425,799)
============ ============
Weighted average number of common shares
outstanding - basic and diluted 13,326,810 11,090,153
============ ============
Basic and diluted net loss per share applicable to common shareholders (0.32) $ (0.27)
============ ============
See accompanying notes to unaudited condensed consolidated financial statements.
INCENTRA SOLUTIONS, INC.
CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS'
DEFICIT AND COMPREHENSIVE LOSS
THREE MONTHS ENDED MARCH 31, 2006
(unaudited)
ACCUMULATED
COMMON STOCK OTHER
------------------------------ ADDITIONAL COMPREHENSIVE ACCUMULATED
SHARES AMOUNT PAID-IN CAPITAL LOSS DEFICIT TOTAL
------------- ------------- --------------- -------------- ------------- ------------
BALANCES, JANUARY 1, 2006 13,326,810 $ 13,327 $ 119,517,168 $ (103,235) $(132,644,333) $ (13,217,073)
Amortization of stock based
compensation expense 426,857 426,857
Accretion of FPDI mandatorily
redeemable preferred
stock to redemption amount (654,392) (654,392)
Warrants issued to Laurus
related to 2006 Facility
(Note 6C) 1,231,071 1,231,071
Components of
comprehensive loss:
Net loss (3,636,461) (3,636,461)
Change in foreign currency
translation adjustments 8,022 8,022
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Total comprehensive loss (3,628,439)
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BALANCES, MARCH 31, 2006 13,326,810 $ 13,327 $ 120,520,704 $ (95,213) $(136,280,794) $ (15,841,976)
============= ============= ============= ============= ============= =============
See accompanying notes to unaudited condensed consolidated financial statements.
INCENTRA SOLUTIONS, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
THREE MONTHS ENDED MARCH 31,
2006 2005
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Cash flows from operating activities:
Net loss $(3,636,461) $(2,348,566)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation 388,951 394,700
Amortization of intangible assets and software development costs 871,577 890,454
Amortization of non-cash loan discount -- 10,188
Stock-based compensation 426,857 155,515
Non-cash interest expense 296,566 526,447
Non-cash loss on early extinguishment of debt 750,362 --
Non-cash tax expense 94,339 318,000
Bad debt expense 5,860 --
Gain on revaluation derivative warrant liability -- (341,495)
Changes in operating assets and liabilities, net of business acquisitions (2005):
Accounts and other receivables 1,147,043 (965,496)
Other current assets (18,316) (90,777)
Other assets 15,034 (17,462)
Accounts payable 238,112 296,984
Accrued liabilities (399,619) (80,677)
Deferred revenue (311,450) 424,404
Other liabilities (91,713) (66,212)
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Net cash used in operating activities (222,858) (893,993)
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Cash flows from investing activities:
Purchases of property and equipment (573,664) (155,995)
Capitalized software development costs (405,828) (399,311)
Proceeds from sale of property and equipment -- 750
Cash acquired in STAR acquisition (Note 4A) -- 1,597,498
Cash acquired in PWI acquisition (Note 4B) -- 74,297
Net change in restricted cash 42,910 (175)
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Net cash (used in) provided by investing activities (936,582) 1,117,064
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Cash flows from financing activities:
Proceeds from line of credit, net 478,639 164,177
Proceeds from lease line of credit 414,514
Payments on capital leases, notes payable and other long term liabilities (394,484) (1,213,386)
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Net cash provided by (used in) financing activities 498,669 (1,049,209)
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Effect of exchange rate changes on cash and cash equivalents 9,312 (36,412)
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Net decrease in cash and cash equivalents (651,459) (862,550)
Cash and cash equivalents at beginning of period 1,108,642 3,068,458
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Cash and cash equivalents at end of period $ 457,183 $ 2,205,908
=========== ===========
Supplemental disclosures of cash flow information:
Cash paid during the period for interest $ 332,368 $ 99,676
Supplemental disclosures of non-cash investing and financing activities:
Net liabilities acquired in Incentra of CA acquisition, excluding cash (Note 4A) -- 620,178
Net assets aquired in PWI acquisition, excluding cash (Note 4B) -- 269,306
Purchases of property and equipment included in accounts payable 302,575 80,279
See accompanying notes to unaudited condensed consolidated financial statements.
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
UNAUDITED
(1) ORGANIZATION
Incentra Solutions, Inc. (which is referred to herein together with its
subsidiaries as "we", "us" or "our"), formerly Front Porch Digital, Inc.
("FPDI"), 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., and our common stock now trades on the Over-the-Counter Bulletin Board
under the trading symbol "ICNS". We have 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, formerly 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 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 market our complete storage solutions to broadcasters under the
trade name Front Porch Digital and to service providers and enterprise clients
under the trade name ManagedStorage International. Through FPDI, 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. 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 that meet 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, the United Kingdom, Bermuda and Japan.
MSI delivers these services 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.
Through Incentra of CA and PWI, we deliver complete IT solutions,
including professional services, third-party hardware/software procurement and
resale, financing solutions, maintenance support services (first call) for
third-party hardware and software maintenance and managed storage solutions.
Solutions are sold primarily to enterprise customers in the financial services,
government, hospitality, retail, security, healthcare and manufacturing sectors.
Incentra of CA and PWI primarily service customers in the western United States.
Our customers are located in North and South America, Europe, Asia and
the Pacific Rim.
BASIS OF PRESENTATION
The unaudited condensed consolidated financial statements include
Incentra Solutions, Inc. and its wholly-owned subsidiaries, Front Porch Digital
International, SAS, which is based in France, MSI, which is based in Colorado,
and MSI's wholly-owned subsidiaries, ManagedStorage UK, Inc. and
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
Seabrook Technologies, Inc., Incentra of CA, which is based in San Diego,
California, and PWI, which is based in Kirkland, Washington. ManagedStorage UK,
Inc. and Seabrook Technologies, Inc. did not have any operating activities
during the quarter ended March 31, 2006. All significant intercompany accounts
and transactions have been eliminated in consolidation.
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 footnote 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 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. For further information, refer to the consolidated financial
statements and footnotes included in our Annual Report on Form 10-KSB for the
year ended December 31, 2005 filed with the SEC on April 4, 2006.
GOING CONCERN AND MANAGEMENT'S PLANS
Our unaudited condensed consolidated financial statements as of March
31, 2006 and for the quarter then ended have been prepared on a going concern
basis, which contemplates the realization of assets and settlements of
liabilities and commitments in the normal course of business. Our audited
consolidated financial statements for the year ended December 31, 2005 were also
prepared on a going concern basis. In our Annual Report on Form 10-KSB for the
year ended December 31, 2005, the Report of our Independent Registered Public
Accounting Firm includes an explanatory paragraph that describes substantial
doubt about our ability to continue as a going concern as a result of nearly all
of our long term debt being callable due to a dispute with a creditor as
discussed below and in Notes 4(A) and 6(E) to these unaudited condensed
consolidated financial statements.
We are currently engaged in an arbitration proceeding to resolve a
dispute with one of our creditors that, if resolved unfavorably, would have a
material adverse affect on our liquidity and financial condition. In connection
with our acquisition of Incentra of CA in February of 2005, we issued the former
owner of Incentra of CA a promissory note in the principal amount of $2,500,000
(the "STAR Note"). On August 1, 2005 we elected to cease making payments on the
STAR Note, which created an event of default. On August 16, 2005, we received a
demand for arbitration from legal counsel of the former owner. In the event the
dispute is not resolved in our favor, the full outstanding balance of the STAR
Note could be accelerated. As a result, the entire balance of the STAR Note,
which totals $2.4 million, is classified as a current liability at March 31,
2006 as it is callable. We do not have the cash available to pay such amount
and, in such event, we would require additional financing to meet our
obligation. There can be no assurance that we would be able to obtain additional
funding when needed, or that such funding, if available, will be obtainable on
terms acceptable to us. See Note 6(E).
The event of default on the STAR Note created an event of default under
our Senior Secured Convertible Note outstanding with Laurus Master Fund Ltd.
("Laurus"), our senior secured lender. As a result, the entire balance of this
Note, which totaled $2.9 million at March 31, 2006 prior to discount, has been
classified as a current liability at March 31, 2006 as it is callable. See Note
6(A). In the event our operations do not generate sufficient cash flow, or we
cannot obtain additional funds if and when needed, we may be forced to curtail
or cease our activities, which would likely result in the loss to investors of
all or a substantial portion of their investment.
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
We believe we have a solid relationship with Laurus; however, there is
uncertainty regarding our ability to comply with required debt covenants in the
future, which places the debt in a position to be called due. This raises
substantial doubt about our ability to continue as a going concern. Our ability
to continue as a going concern is dependent on future financial results, the
results of the arbitration proceeding discussed above and, should we continue to
be in breach of the covenants on the debt, our ability to restructure or
otherwise amend the terms of that debt. Our financial statements do not include
any adjustments to reflect the possible future effects on the recoverability and
classification of assets or the amounts and classifications of liabilities that
might result from the outcome of this uncertainty.
Management's plans in regard to these matters are as follows:
If we continue to be in default of our covenants in the future, we
would, as we have in the past, seek to obtain amendments to the debt or waivers
of the covenants so that we are no longer in violation.
While we believe we will execute our current business plan, which calls
for growth in our business, we will also institute various cost controls to
reduce operating expenses where necessary. This includes the timely monitoring
of labor and selling, general and administrative costs.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
IMPAIRMENT OF LONG-LIVED ASSETS
In accordance with Statement of Financial Accounting Standards (SFAS)
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", we
review the carrying value of long-lived assets, including property and equipment
and amortizable intangible assets, to determine whether there are any
indications of impairment. Impairment of long-lived assets is assessed by a
comparison of the carrying amount of an asset to expected future cash flows to
be generated by the asset. If the assets are considered to be impaired, the
impairment recognized is measured by the amount by which the carrying amount of
the assets exceeds the estimated fair value of the assets. At March 31, 2006, we
believe that there are no indicators that an impairment of any long-lived assets
has occurred.
GOODWILL
Goodwill represents the excess of the purchase price over the net of
the fair value of the identifiable tangible and intangible assets acquired and
the fair value of liabilities assumed in acquisitions. SFAS No. 142, "Goodwill
and Other Intangible Assets," (SFAS 142) requires the testing of goodwill and
indefinite-lived intangible assets for impairment at least annually. We test
goodwill for impairment in the fourth quarter of each year or during interim
periods if factors indicating impairment concerns arise.
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
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
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 whom 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 amortization over an estimated useful life of three years.
For the three-month periods ended March 31, 2006 and 2005, capitalized
software development costs, which related primarily to enhancements to our
GridWorks and DIVArchive software solutions, totaled $405,828 and $399,311,
respectively. These costs are amortized on a straight-line basis over the
estimated life of the enhancements, typically three years. For the three-month
periods ended March 31, 2006 and 2005, $227,030 and $117,734, respectively, of
amortization costs were charged to expense. As of March 31, 2006, the
unamortized portion of software development costs was $2,312,001.
FOREIGN CURRENCY TRANSLATION AND TRANSACTIONS
The balance sheet accounts of our international subsidiary (Front Porch
Digital International, SAS) 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. At March 31, 2006, we reported a
cumulative translation loss of $95,213 as a component of accumulated other
comprehensive income (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-month periods ended March 31, 2006
and 2005 were gains of $1,290 and $82,189, respectively.
ACCOUNTING FOR OBLIGATIONS AND INSTRUMENTS POTENTIALLY SETTLED IN THE COMPANY'S
COMMON STOCK
We account for obligations and instruments potentially to be settled in
our stock in accordance with Emerging Issues Task Force ("EITF") No. 00-19,
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
"Accounting for Derivative Financial Instruments Indexed To, and Potentially
Settled In a Company's Own Stock." ("EITF No. 00-19") This issue addresses the
initial balance sheet classification and measurement of contracts that are
indexed to, and potentially settled in, our own stock.
Under EITF No. 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. The classification of a contract is
reassessed at each balance sheet date.
PER SHARE DATA
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 our
financial statements for the three-month period ended March 31, 2006 and in
prior periods, have been adjusted to reflect the post-reverse split amounts.
We report our earnings (loss) per share in accordance with SFAS No.
128, "Accounting for Earnings Per Share". 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 and stock splits, the historical
loss per share amounts have been retroactively restated to reflect our capital
structure. Due to our net losses for the periods presented, 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 months ended March 31, 2006 and 2005 because the effect
would be antidilutive.
An aggregate of 13.2 million and 10.1 million shares of common stock
issuable upon the conversion of outstanding convertible preferred stock, the
exercise of outstanding options and warrants, and restricted stock have been
omitted from the computations of basic and diluted loss per share for the
three-month periods ended March 31, 2006 and 2005, respectively, because the
effect would be antidilutive.
STOCK-BASED COMPENSATION
On December 16, 2004, the Financial Accounting Standards Board (FASB)
issued SFAS 123 (revised 2004), "Share-Based Payment" (SFAS 123R). SFAS 123R
supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees", and
amends SFAS No. 95, "Statement of Cash Flows". Generally, the approach in SFAS
123R is similar to the approach described in SFAS 123. However, SFAS 123R
requires all share-based payments to employees, including grants of employee
stock options, to be recognized in the income statement based on their fair
values at the date of grant. Pro forma disclosure is no longer an alternative.
On January 1, 2006 (the first day of our 2006 fiscal year), we adopted
SFAS 123R using the modified prospective method as permitted under SFAS 123R.
Under this transition method, compensation cost recognized in the first quarter
of 2006 includes: (a) compensation cost for all share-based payments granted
prior to but not yet vested as of December 31, 2005, based on the grant-date
fair value estimated in accordance with the provisions of SFAS 123, and (b)
compensation cost for all share-based payments granted subsequent to December
31, 2005, based on the grant-date fair value estimated in accordance with the
provisions of SFAS 123R. In accordance with the
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
modified prospective method of adoption, our results of operations and financial
position for prior periods have not been restated.
We use the Black-Scholes option pricing model to calculate the
grant-date fair value of an award. The fair value of options granted during the
first quarter of 2006 (there were no option grants during the first quarter of
2005) was calculated using the following estimated weighted average assumptions:
Stock options granted 50,000
Weighted-average exercise price $ 1.11
Weighted-average grant date fair value $ 0.95
Assumptions:
Expected volatility 113%
Expected term (in years) 6 years
Risk-free interest rate 4.62%
All of our employee options vest over three years, which is considered
to be the requisite service period. We use the graded vesting attribution method
to recognize expense for all options granted prior to the adoption of SFAS 123R.
Upon adoption of SFAS 123R on January 1, 2006, we switched to the straight-line
attribution method to recognize expense for options granted after December 31,
2005. The expense associated with the unvested portion of the pre-adoption
grants will continue to be expensed using the graded vesting attribution method.
The amount of stock-based compensation recognized during a period is
based on the value of the portion of the awards that are ultimately expected to
vest. SFAS 123R requires forfeitures to be estimated at the time of grant and
revised, if necessary, in subsequent periods if actual forfeitures differ from
those estimates. The term "forfeitures" is distinct from "cancellations" or
"expirations" and represents only the unvested portion of the surrendered
option. We currently expect, based on an analysis of historical forfeitures that
approximately 90% of our options will actually vest, and therefore have applied
a forfeiture rate of 3.5% per year to all unvested options as of March 31, 2006.
This analysis will be re-evaluated quarterly and the forfeiture rate will be
adjusted as necessary. Ultimately, the actual expense recognized over the
vesting period will only be for those shares that vest.
Expected volatilities are based on the historical volatility of the
price of our common stock. The expected term of options is derived based on the
sum of the vesting term plus the original option term, divided by two.
The adoption of SFAS 123R on January 1, 2006 had the following impact
on the first quarter of 2006 results: net loss before deemed dividends and
accretion on preferred stock increased by $0.4 million and net loss per weighted
average common share outstanding--basic and diluted increased by $.03 per share.
The following table details the effect on net loss before deemed dividends and
accretion on preferred stock and net loss per weighted average common share
outstanding had stock-based compensation been recorded for the first three
months of 2005 based on the fair-value method under SFAS 123, "Accounting for
Stock-Based Compensation". The reported and pro forma net loss before deemed
dividends and accretion on preferred stock and net loss per weighted average
common share for the first quarter of 2006 are the same since stock-based
compensation expense was calculated under the provisions of SFAS 123R. All
amounts except per share amounts in 000's:
Three Months Ended
March 31, 2005
--------------
Net loss before deemed dividends and accretion
on preferred stock , as reported $(2,349)
Add stock-based compensation expense included in
reported net loss 156
Deduct total stock-based employee compensation expense
determined under the fair-value based method for all awards (510)
-------
Pro forma net loss before deemed dividends and
accretion on preferred stock $(2,703)
=======
Net loss per weighted average common share outstanding--
Basic and diluted--pro forma $ (.30)
=======
Net loss per weighted average common share outstanding-
Basic and diluted-as reported $ (.27)
=======
Summaries of option activity under the plans as of March 31, 2006, changes
during the quarter then ended, and status of non-vested options are presented
below:
Weighted Weighted
Number of Average Average
Options Exercise Price Contractual Life
--------- -------------- ----------------
Balance January 1, 2006 2,217,016 $ 2.92 $ 8.50
Granted 50,000 1.11 10.00
Exercised - - -
Forfeited (28,267) 5.09 (8.70)
--------- ------ ------
Balance March 31, 2006 2,238,749 2.85 8.30
========= ====== ======
Vested Balance at March 31, 2006 878,693 $ 3.58 $ 7.70
========= ====== ======
Weighted
Average Grant
Date Fair
Value
----------------
Non-vested options at January 1, 2006 1,379,524 $ 2.42 $ 0.52
Granted 50,000 1.11 0.95
Vested (48,203) 2.30 (1.35)
Forfeited (21,265) 2.16 (0.94)
--------- ------
Non-vested options at March 31, 2006 1,360,056 $ 2.38 $ 0.50
As of March 31, 2006, there was $2.2 million of total unrecognized
compensation expense related to the non-vested, share-based compensation
arrangments granted under the plans. That cost is expected to be recognized over
a weighted-average period of 1.42 years. The total fair value of shares vested
during the quarter ended March 31, 2006 was approximately $43,000.
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires us to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting periods. Actual results could differ from those estimates. We have
recorded transactions that include the issuance of options and warrants to
purchase shares of our preferred and common stock. The accounting for such
securities is based upon fair values of our equity securities and other
valuation criteria that were determined by our Board and us. We believe these
estimates of fair value are reasonable. Other significant estimates made by us
include those related to fair values of acquired intangible assets, and the
establishment of an allowance for estimates of uncollectible accounts
receivable.
(3) CONCENTRATIONS OF CREDIT RISK
We sell our products and services throughout the United States, Europe,
Asia and the Pacific Rim. We perform periodic credit evaluations of our
customers' financial condition and generally do not require collateral. Accounts
receivable are reported at their outstanding unpaid principal balances reduced
by an allowance for doubtful accounts. We estimate doubtful accounts based on
historical bad debts, factors related to a specific customer's ability to pay
and current economic trends. We write off accounts receivable against the
allowance when a balance is determined to be uncollectible. Credit losses have
been within management's expectations.
For the quarter ended March 31, 2006, aggregate revenues from customers
located in Europe, Asia and the Pacific Rim amounted to $4.1 million or 32% of
total revenue, while revenues from customers located in North America totaled
$8.8 million, or 68% of total revenue. For the quarter ended March 31, 2005,
aggregate revenues from customers located in Europe, Asia and the Pacific Rim or
in North America both amounted to $3.0 million or 50% of total revenue in each
case. For the quarter ended March 31, 2006, no one customer accounted exceeded
10% of total revenues nor did any single customer account for over 10% of
accounts receivable at March 31, 2006. For the quarter ended March 31, 2005, no
one customer exceeded 10% of revenue.
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
(4) ACQUISITIONS
(A) ACQUISITION OF INCENTRA OF CA, FORMERLY 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
financial statements beginning on February 18, 2005.
Pursuant to the STAR Merger Agreement, the purchase price consisted of
(i) a cash payment of $1,500,000, (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"). We
entered into a consulting agreement with the seller pursuant to which we agreed
to pay consulting fees in the amount of $500,000 which was included as part of
the purchase price. 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 by $300,000 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, which commenced 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. As of March 31, 2006, we classified the entire
principal amount of $2.4 million to current liabilities based on the default, as
the debt is now callable. Refer to Note 6(E).
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 March 31, 2006 and pending the results of the arbitration proceedings
described in Note 6(E), the principal balance on 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.
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 purchase price allocation at the date of
the Incentra of CA acquisition:
Cash and cash equivalents $ 1,597,498
Other current assets 824,998
Property and equipment 20,909
Other assets 7,005
Goodwill 6,177,686
Customer relationships (5 year life) 540,000
Current liabilities (1,473,088)
-----------
Total purchase price $ 7,695,008
===========
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
The purchase price allocation was considered final as of December 31,
2005. As a result of the goodwill impairment test we completed in the fourth
quarter of 2005 in accordance with SFAS 142, the amount allocated to goodwill
was considered impaired and an impairment loss of $4,151,450 was charged to
income in the fourth quarter of 2005.
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 $2,350,000 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, during the year
ended December 31, 2005, the former PWI shareholders achieved a partial earn out
of $100,000 which was paid to them in cash. As a result of the earn-out payment,
the purchase price (goodwill) was increased by $100,000. We paid approximately
$250,000 in investment banking fees in connection with the transaction.
Concurrent 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 have "piggy-back" registration rights with
respect to such shares.
The following represents the purchase price allocation at the date of
the PWI acquisition:
Cash and cash equivalents $ 74,297
Other current assets 7,009,601
Property and equipment 173,610
Other assets 28,010
Goodwill 3,831,534
Customer relationships (5 year life) 310,000
Current liabilities (6,877,351)
Other liabilities (64,564)
-----------
Total purchase price $ 4,485,137
===========
The purchase price allocation was considered final as of December 31,
2005.
C) PROFORMA RESULTS
The following unaudited pro forma financial information presents our
combined results of operations for the first quarter of 2005 as if the
acquisitions of Incentra of CA and PWI had occurred as of January 1, 2005. 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
period presented, and should not be taken as representative of our future
consolidated results of operations or financial condition. Unaudited pro forma
results were as follows for the three-month periods ended March 31, 2006 and
2005:
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
Three-month periods ended
March 31,
2006 2005
------------ ------------
(Unaudited) (Unaudited)
Revenue $ 12,909,171 $ 16,452,125
Cost of revenue 7,791,490 11,971,102
------------ ------------
Gross margin 5,117,681 4,481,023
Operating expenses 6,739,828 6,377,743
------------ ------------
Loss from operations (1,622,147) (1,896,720)
Other expense, net (1,919,975) (184,604)
Income tax expense (94,339) (319,607)
------------ ------------
Net loss (3,636,461) (2,400,931)
Accretion of redeemable preferred
stock to redemption amount (654,392) (654,391)
------------ ------------
Net loss applicable to common
shareholders $ (4,290,853) $ (3,055,322)
============ ============
Net loss per share applicable to
common shareholders-basic and diluted $ (0.32) $ (0.29)
============ ============
(5) PROPERTY AND EQUIPMENT
Property and equipment consisted of the following as of March 31, 2006:
Computer equipment $ 5,225,499
Software 1,640,110
Leasehold improvements 63,246
Assets under construction 172,209
Office furniture and equipment 758,345
-----------
7,859,409
Less accumulated depreciation (5,441,470)
-----------
$ 2,417,939
===========
Depreciation expense for the three-month periods ended March 31, 2006
and 2005 was $388,951 and $394,700, respectively.
Included in property and equipment was equipment under capital leases
with a cost of $2,130,065 and accumulated depreciation of $830,437 at March 31,
2006.
(6) NOTES PAYABLE, CAPITAL LEASES, AND OTHER LONG-TERM OBLIGATIONS
The following is a summary of our long-term debt as of March 31, 2006:
Senior Secured Convertible Note (A) $ 2,371,954
Lines of Credit (B) and (C) 5,292,689
Acquisition Term Notes (D) 0
STAR Note (E) 2,106,281
Capital Leases (F) 901,040
Other obligations 524,846
------------
11,196,810
Less current portion (10,964,731)
------------
Long-term portion $ 232,079
============
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
(A) SENIOR SECURED CONVERTIBLE NOTE
On May 13, 2004, we consummated a private placement pursuant to which
we issued a secured convertible term note due May 13, 2007 (the "Maturity Date")
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 are
convertible into shares of our common stock at a price of $3.00 per share,
subject to adjustments for standard antidilution provisions.
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 $108,986 and $139,545 of additional non-cash
interest expense relating to the amortization of the discount for the
three-month periods ended March 31, 2006 and 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. However, as a result of
the one-for-ten reverse stock split effected on June 9, 2005, there were again
sufficient authorized and unissued common shares to settle the Laurus Warrant,
and it was again reclassified and is included in equity through March 31, 2006.
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, at the
rate of $45,455 per month and increased to approximately $159,000 per month
beginning in March 2005, with the balance payable on the Maturity Date. However,
due to an event of default on the STAR Note (see Note 6(E)), all amounts due
under the Laurus Note have been reclassified to current liabilities at March 31,
2006.
Laurus has the option to receive shares of our common stock in lieu of
debt service payments at a fixed price of $3.00 per share. The Laurus Note 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 standard
antidilution adjustments.
On February 6, 2006, we entered into an Amendment and Deferral
Agreement (the "Amendment and Deferral Agreement") with Laurus amending the
Laurus Note. Pursuant to the Amendment and Deferral Agreement, the monthly
principal amount of the Laurus note payable to Laurus for each of January,
February, March, April, May and June 2006, equal to an aggregate of $952,495, is
deferred until the Maturity Date.
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
(B) 2005 LINE OF CREDIT
In June 2005, we entered into a Security Agreement with Laurus pursuant
to which Laurus provided us a $9 million revolving, convertible credit facility
(the "2005 Facility"). The term of the 2005 Facility was three years. In
connection with the 2005 Facility, we executed in favor of Laurus a $9 million
Secured Revolving Note (the "Revolver Note").
Borrowings under the 2005 Facility were 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 2005 Facility was guaranteed by PWI and Incentra of CA
pursuant to a Subsidiary Guaranty in favor of Laurus.
In connection with the financing, we issued to 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, subject to adjustment
for standard antidilution provisions (the "2005 Warrant"). The value of the
warrant was determined, using the Black-Scholes model, to be $0.6 million and
was recorded as a debt discount.
All borrowings under the 2005 facility were repaid in full in February
2006 and the balance of the debt discount, $448,533, and the deferred financing
costs, $301,140, were included in the loss on the early extinguishment of debt.
(C) 2006 LINE OF CREDIT
On February 6, 2006, we entered into the New Security Agreement with
Laurus pursuant to which Laurus agreed to provide us with a non-convertible
revolving credit facility of up to $10 million (the "2006 Facility"). The term
of the 2006 Facility is three (3) years and borrowings under the 2006 Facility
accrue interest on the unpaid principal and interest at a rate per annum equal
to the prime rate plus 1%, subject to a floor of 7%. In connection with the 2006
Facility, we executed in favor of Laurus a secured non-convertible revolving
note in the principal amount of $10 million (the "2006 Revolving Note").
Interest on borrowings under the 2006 Revolving Note is payable monthly on the
first day of each month during the term of the 2006 Revolving Note, commencing
on March 1, 2006. All outstanding principal amounts are due and payable on
February 6, 2009.
We entered into the 2006 Facility to pay off the 2005 Facility, of
which approximately $6 million was outstanding as of February 6, 2006. In
connection with the 2006 Facility, we issued to Laurus an option to purchase
1,071,428 shares of common stock at a price of $.001 per share. The Option
expires on February 26, 2026. Pursuant to the 2006 Facility, Laurus may not sell
any shares of our common stock it receives through the exercise of the Option
(the "Option Shares") prior to January 31, 2007. Additionally, Laurus agreed not
to sell an amount of Option Shares that would exceed thirty-five percent (35%)
of the aggregate dollar trading volume of our Common Stock for the twenty-two
(22) trading day period immediately preceding such sale. Using the Black-Scholes
model, we calculated the value of the Option to be $1.2 million and recorded a
debt discount of the same amount to be amortized over 36 months beginning in
February 2006. In conjunction with the payoff of the 2005 Facility, we incurred
a loss on the early extinguishment of that debt of $1.2 million.
The 2006 Facility increased the minimum initial amount of borrowings
available to us and to our subsidiaries from $6 million under the 2005 Facility
to $6.48 million under the 2006 Facility until April 30, 2006. Thereafter, the
maximum principal amount of all borrowings under the 2006 Facility cannot exceed
90% of the eligible accounts receivable of our company and each of our U.S.
subsidiaries, minus any reserves that Laurus may in good faith deem necessary
and appropriate.
On February 6, 2006, we requested and Laurus agreed to lend an initial
draw under the 2006 Facility of $6.38 million, of which (i) approximately $5.9
million was used to satisfy in full our indebtedness to Laurus under the 2005
Facility, (ii) $375,000 was paid to Laurus as an early termination fee for the
2005 Facility and (iii) $107,500 (recorded as expense) was applied
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
towards costs of the 2006 Facility. Both of the two latter amounts were included
in the loss on the early extinguishment of debt.
All loans and obligations owed by us to Laurus arising under the 2006
Facility or otherwise are secured by a security interest in substantially all of
the assets of our company and our subsidiaries pursuant to the terms of the
Security Agreement.
In addition, we pledged to Laurus all of the outstanding capital stock
of our subsidiaries pursuant to a Stock Pledge Agreement (the "Stock Pledge
Agreement") executed by us in favor of Laurus, and each of our subsidiaries
executed a Subsidiary Guaranty, dated February 6, 2006 (the "Subsidiary
Guarantee"), in favor of Laurus, guaranteeing all of our present and future
obligations to Laurus.
Under the terms of the 2006 Facility, if an event of default occurs
under any of our agreements with Laurus, Laurus has the right to accelerate
payments in addition to any other remedies available to it and to foreclose upon
the assets securing the borrowings. If an event of default occurs under any of
our agreements with Laurus, within five days after written notice to us, Laurus
may require a payment of 125% of the unpaid principal balance, plus accrued
interest and fees, which will become immediately due and payable. Laurus would
also be entitled to payment of a default interest rate of 1.5% per month on all
amounts due. No events of default exist at March 31, 2006.
The 2006 Facility contains certain negative covenants that require us
to obtain the prior written consent or other actions of Laurus in order for us
to take certain actions at any time when borrowings remain outstanding under the
2006 Facility.
Pursuant to the terms of an Amended and Restated Registration Rights
Agreement between us and Laurus (the "Registration Rights Agreement"), which
amends and restates a Registration Rights Agreement between Laurus and our
company dated May 13, 2004, we are obligated to file a post-effective amendment
to our existing Registration Statement on Form SB-2 originally filed on June 29,
2004 to include the shares of common stock issuable (i) upon exercise of the
Option, (ii) as a result of adjustments made to the exercise price of the
Option, (iii) upon exercise of the warrant issued pursuant to the June 30, 2005
Security Agreement, and (iv) as a result of adjustments made to the exercise
price of such warrant. We anticipate filing a Registration Statement in May
2006.
(D) ACQUISITION TERM NOTES
On March 31, 2006, we consummated a private placement with Laurus
pursuant to which we issued to Laurus a secured term note due May 31, 2009 in
the principal amount of $1,750,000 (the "2006 Term Note") and a secured
convertible term note due May 31, 2009 in the principal amount of $1,500,000
(the "2006 Convertible Note"). In connection with the issuance of the 2006 Term
Note and the 2006 Convertible Note, we issued to Laurus a common stock purchase
warrant (the "2006 Warrant") entitling the holder to purchase 417,857 shares of
common stock (the "2006 Warrant") at $0.001 per share, subject to certain
antidilution adjustments, at any time after March 31, 2007 and on or prior to
March 31, 2013. The 2006 Term Note, 2006 Convertible Note and the 2006 Warrant
were sold to Laurus for a purchase price of $3,250,000 and were funded on April
13, 2006 in connection with the acquisition discussed in Note 8.
The 2006 Term Note and 2006 Convertible Note provide for monthly
payments of interest at a rate per annum equal to the prime rate plus 2%,
subject to a floor of 9%. The 2006 Term Note and 2006 Convertible Note also
provide for monthly amortization of principal, which commences on August 1,
2006, at the rate of $101,563 per month. The principal and unpaid interest on
the 2006 Convertible Note are convertible into shares of our common stock at a
fixed conversion price of $1.40 per share (which exceeded the market price of
our common stock on March 31, 2006), subject to certain antidilution
adjustments. The 2006 Term Note and 2006 Convertible Note are collateralized by
a security interest in all of our assets.
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
Pursuant to a Registration Rights Agreement (the "2006 Registration
Rights") with Laurus, we are obligated to: (a) file on or prior to May 15, 2006
a registration statement under the Securities Act ("Registration Statement") to
register the resale of the shares of our common stock issuable upon conversion
of the 2006 Convertible Note and exercise of the 2006 Warrant (b) use our best
efforts to have the Registration Statement declared effective under the
Securities Act as promptly as possible, but in any event prior to July 15, 2006
and (c) maintain the effectiveness of the Registration Statement until the
earliest date of when (i) all Registrable Securities covered by such
Registration Statement have been sold, or (ii) all Registrable Securities
covered by such Registration Statement may be sold immediately without
registration under the Securities Act and without volume restrictions pursuant
to Rule 144(k) under the Securities Act, or (iii) except with respect to the
shares issuable upon the exercise of the 2006 Warrant, all amounts payable under
the 2006 Convertible Note have been paid in full. Laurus, or other holders of
the 2006 Convertible Note and the 2006 Warrant, are entitled to certain
specified remedies if we do not timely comply with our registration obligations.
Pursuant to the 2006 Securities Purchase Agreement (the "Securities
Purchase Agreement") with Laurus, for so long as 25% of the original principal
amount of the 2006 Convertible Note is outstanding or the 2006 Warrant is
outstanding, we may not directly or indirectly declare or pay any dividends
without the prior written consent of Laurus. The 2006 Securities Purchase
Agreement also requires the written consent of Laurus in connection with any
1iquidation, material reorganization, merger or acquisition involving our
company, or the issuance of certain additional indebtedness by our company.
The 2006 Term Note and 2006 Convertible Note contain certain events of
default consistent with those encompassed in our previous financings with
Laurus. Following the occurrence and during the continuance of any such event of
default, we are required to pay additional interest in an amount equal to (1.5%)
per month, and all outstanding obligations, including unpaid interest, shall
continue to accrue interest at such additional interest rate from the date of
such event of default until the date such event of default is cured or waived.
In addition, following the occurrence and during the continuance of any such
event of default, Laurus, at its option, may demand repayment in full of all
obligations and liabilities owing to Laurus and/or may elect, in addition to all
rights and remedies of Laurus, require us to make a default payment equal to
125% of the outstanding principal amount of the Note, plus accrued but unpaid
interest, all other fees then remaining unpaid, and all other amounts payable by
us to Laurus.
(E) STAR NOTE
Pursuant to the STAR Merger Agreement discussed in Note 4(A), we issued
an unsecured convertible promissory note for $2,500,000 to the principal
stockholder of Incentra of CA (the "STAR Note") that is payable in ten
installments and matures on August 1, 2007. 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.
On August 1, 2005, we elected not to make a scheduled payment due under
the STAR Note after we identified significant required post-closing adjustments
to the purchase price for the assets of STAR and, consequently,
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
the principal amount of the STAR Note. On August 16, 2005, we received a demand
for arbitration from legal counsel of the principal stockholder. As of March 31,
2006, we have classified the entire principal amount to current liabilities
based on the default. We have been accruing interest at the 12% default rate
since August 11, 2005.
We are engaged in an arbitration proceeding to resolve this dispute,
which if resolved unfavorably, would have a material adverse affect on our
liquidity and financial condition since payment of the full outstanding balance
of the STAR Note could be accelerated. The hearing phase of the arbitration
proceeding was completed in April 2006, and both parties have submitted their
proposed findings of fact and conclusions of law to the arbitrator. A ruling
from the arbitrator is expected by the end of June 2006. As of the balance sheet
date, the entire principal balance of $2.4 million ($2.1 million net of
discount) on the STAR Note is classified as current. 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.
The event of default on the STAR Note created an event of default of
certain provisions of the Laurus Note. Because Laurus has not granted us a
waiver of the default on this indebtedness at March 31, 2006, the entire amount
due under the Laurus Note has also been classified with current liabilities.
Other indebtedness with Laurus discussed in Notes 6(B) and 6(D) was not affected
by the event of default on the STAR Note.
(F) CAPITAL LEASES
In 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. On March
2, 2005, we entered into an amendment to the Lease Line. Under this amendment,
we could draw an additional $500,000 (the "New Credit Facility") for equipment
purchases through June 30, 2005, of which we used $497,667. The amendment also
granted to us a call option to purchase equipment from the lessor. The term of
the agreement is for 15 months with an interest rate of 14.96% per annum.
On September 11, 2005, we entered into Amendment No. 2 to the Lease
Line. Under this amendment, we were able to draw an additional $1,000,000 (the
"Amended Credit Facility") for equipment purchases through December 31, 2005.
The amendment also granted to us a call option to purchase equipment from the
lessor. The terms of the agreement are for lease terms of 12-15 months with
interest rates ranging from 14.964% to 15%. The Amended Credit Facility is to be
repaid in monthly principal and interest installments through September 2006.
During the first quarter of 2006, the period of time in which we were able to
draw under the Amended Credit Facility was informally extended at no cost to us
to March 31, 2006. During the quarter ended March 31, 2006, we drew $583,407 on
the Lease Line. The unpaid balance at March 31, 2006 was $522,873.
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
(7) SERIES A CONVERTIBLE REDEEMABLE PREFERRED STOCK
We have designated 2.5 million authorized shares of preferred stock as
Series A Preferred shares and issued 2,466,971 of such shares in connection with
an acquisition in 2004. Warrants are outstanding for the purchase of 26,075
Series A Preferred shares at a purchase price of $10.35 per share and 6,954
Series A Preferred shares at a purchase price of $6.02 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
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).
(8) SUBSEQUENT EVENT ACQUISITION OF NETWORK SYSTEM TECHNOLOGIES, INC.
On April 13, 2006 (the "NST Closing Date"), we acquired all of the
outstanding capital stock (the "NST Stock") of Network System Technologies,
Inc., an Illinois corporation ("NST"), pursuant to a Stock Purchase Agreement,
dated as of the Closing Date (the "NST Stock Purchase Agreement").
The consideration paid for the NST Stock on the NST Closing Date was
approximately $8.2 million, which consisted of $5.5 million in cash, the
issuance of 1,034,483 shares of our common stock and the issuance of an
unsecured promissory note in the amount of $1.5 million (the "NST Note"). In
addition, the NST Stock Purchase Agreement contains an earn-out provision
pursuant to which Transitional Management Consultants, Inc. ("TMC"), a
newly-formed corporation owned by the former NST shareholder, may receive
additional unregistered shares of our common stock based upon certain levels of
EBITDA (as defined in the Stock Purchase Agreement) achieved by NST during the
twenty-four month period ending March 31, 2008. The maximum number of shares
issuable under the earn-out is 1,120,690 shares (subject to customary
adjustments for stock splits, stock dividends and similar transactions) if NST's
EBITDA is $4 million or greater during such period and provided certain other
conditions are met. In addition, TMC's right to receive the earn-out described
above is subject to the continued provision of consulting services by the former
shareholder through TMC to us through March 31, 2008, with certain exceptions.
If the services terminate prior to such date, TMC may under certain
circumstances receive a pro rated portion of the earn-out amount. The cash paid
on the NST Closing Date was provided pursuant to our existing line of credit and
term note from Laurus Master Fund, Ltd., which was amended on the NST Closing
Date to make NST a co-borrower thereunder.
The NST Note accrues interest at an annual rate of one-half percent
(1/2%). We are required to make eight equal payments of principal and interest
in the amount of $190,190.38, the first payment of which is due on July 15,
2006, and the seven remaining payments being due on the first day of September,
December, March and June during the period beginning on September 1, 2006 and
ending on March 1, 2008. The NST Note further provides that all unpaid principal
and accrued interest shall become immediately due and payable upon the
occurrence of an event of default (as defined in the NST Note). Such events of
default include, among others, the occurrence either of the following events:
INCENTRA SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
UNAUDITED
(i) our failure to make payment when due, subject to a five (5) day notice and
cure period or (ii) our failure to observe, keep or comply with any provision or
requirement contained in the NST Stock Purchase Agreement.
Concurrently with the consummation of the acquisition, we granted
registration rights with respect to the shares of our common stock issued in the
acquisition and we granted registration rights to TMC with respect to the shares
issuable under the earn-out provision contained in the NST Stock Purchase
Agreement. Pursuant to each registration rights agreement executed on the NST
Closing Date, at any time after April 13, 2008, the holders of such rights shall
have the right to cause us to register under the Securities Act, the shares of
our common stock issued on the NST Closing Date and the shares of common stock
issuable pursuant to the earn-out described above. The agreements also provide
that, after April 13, 2008, the holders shall have `piggy-back' registration
rights with respect to such shares.
We also entered into a lock-up agreement with the former shareholder
dated as of the NST Closing Date. Under such agreement, the former shareholder
agreed not to sell or transfer the shares he received pursuant to the NST Stock
Purchase Agreement until after April 13, 2008, with certain exceptions.
In connection with the consummation of the acquisition, we entered into
a consulting and subcontractor agreement (the "Consulting Agreement") dated as
of the NST Closing Date with TMC that provides that TMC will provide consulting
services to us relating to the business of NST and will receive a monthly fee of
$24,251. The agreement has a two-year term and provides that TMC may terminate
the agreement for any reason upon thirty (30) days prior written notice and that
we may terminate the agreement, for cause (as defined in the Consulting
Agreement), at any time upon written notice to TMC. In addition, TMC has the
right to earn an annual cash bonus based upon certain levels of EBITDA (as
defined in the Consulting Agreement) achieved by NST during the twelve (12)
months ended March 31, 2007 and 2008. The maximum bonus amount is equal to
$150,000 plus twenty-five percent (25%) of the amount by which EBITDA exceeds $2
million during the relevant annual period. TMC's right to receive the earn-out
described above is subject to the continued provision of consulting services by
TMC to us through end of each such period, with certain exceptions.
In connection with our acquisition of NST, we paid investment banking
fees to a third party of $475,000.
(B) 2006 STOCK OPTION PLAN
On May 4, 2006, our board of directors approved and adopted the
Incentra Solutions, Inc. 2006 Stock Option Plan (the "Plan"), which provides for
the granting of options to key employees, officers and certain individuals to
purchase shares of the our common stock. We currently have reserved 1,750,000
shares of common stock for issuance under the Plan. The Plan has a term of ten
years and provides for the grant of "incentive stock options" within the
meaining of Section 422 of the Internal Revenue Code of 1986, as amended and
nonstatutory stock options. Options granted under the plan may not have a term
of more than a ten-year period (five years in the case of incentive stock
options granted to employees who hold more than ten percent (10%) of the voting
power of the Company's common stock). Subject to the terms of any award
agreement, options generally terminate three months after the termination of
employment, except in the case of termination for cause or upon death or
disability. We plan to register under the Securities Act of 1933, the shares of
our common stock issuable upon exercise of the options granted pursuant to the
Plan.
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.
Incentra Solutions, Inc. is a leading provider of complete solutions
for the data protection needs of an enterprise. 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
Incentra Solutions of Colorado ("Colorado"), ManagedStorage International
("MSI"), Incentra Solutions of California ("Incentra of CA") and PWI
Technologies ("PWI"). Front Porch provides unique software and professional
services solutions for digital archive management to broadcasters and media
companies.
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. Our complete digital archive
solution includes our proprietary software bundled with professional services,
hardware/software procurement and resale, remote monitoring/management services,
complete support for our proprietary software solutions and first call support
for third-party hardware and software maintenance. Our software converts audio,
video, images, text and data into digital formats for ease of use and archiving.
With more than 115 installations worldwide, our DIVArchive software solution has
become one of the leading digital archive management applications among European
and Asian broadcast and media companies and is gaining an increasing share of
the North American market. Front Porch's DIVArchive and transcoding applications
provide the essential integration layer within the digital content creation and
broadcast environments. All of Front Porch's products were built on intelligent,
distributed architecture. As a result, Front Porch's archive management and
transcoding solutions are flexible, scalable, easily upgradeable, failure
resilient and integratable with leading automation and asset management
applications.
Through MSI, we deliver comprehensive storage services, including
remote monitoring/management services, maintenance support services (first call)
for third-party hardware and software maintenance, professional services,
third-party hardware/software procurement and resale and financing solutions.
MSI provides data protection solutions and services that ensure that its
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 ("NOC") in Broomfield,
Colorado, which monitors and manages a wide spectrum of diverse storage
infrastructures on a 24x7 basis throughout the United States, the United
Kingdom, the Netherlands, Bermuda and Japan. MSI delivers these services
worldwide using 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. We believe customers benefit from
improved operating effectiveness with 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, maintenance support services (first call) for
third-party hardware and software maintenance and managed storage solutions.
Solutions are sold primarily to enterprise customers in the financial services,
government, hospitality, retail, security, healthcare and manufacturing sectors.
Incentra of CA and PWI primarily service customers in the western United States.
Through NST, Inc (which we acquired in April 2006), we provide storage,
networking and security solutions, as well as professional services, to over 300
existing customers in the financial services, healthcare, education, non-profit
and manufacturing verticals in the Chicago, Illinois area and central state
region of the U.S. NST's customer base will provide an immediate market for our
other products, such as First Call and Enhanced First Call support services and
our GridWorks remote monitoring and management system in an area of the U.S.
market not previously available to us with our direct sales force.
The following discussion and analysis of financial condition and
results of operations is based upon our 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.
For the three months ended March 31, 2006, revenues totaled $12.9
million as compared to $6.0 million for the comparable prior period. The rate of
increase for the three-month period ended March 31, 2006 was approximately 115%
when compared to the same period for 2005. The increase in revenue from the
prior year quarter was a result of the acquisitions of Incentra of CA and PWI,
increased sales of hardware as part of complete archive solutions, and an
increase in deliveries of broadcast solutions.
We continue to invest in hardware and the development of our software
and digital archiving in the data storage and infrastructure areas. During the
three months ended March 31, 2006, we invested $0.4 million in software
development and $0.6 million for data storage infrastructure.
During the three months ended March 31, 2006, our loss from operations
decreased by approximately $0.3 million to $1.6 million as compared to a loss of
$1.9 million for the comparable prior-year period. This reduction in our loss
was due to the increase in gross margin generated primarily from increased sales
of our broadcast software solutions, which was offset in part by an increase in
selling, general and administrative costs of approximately $2.0 million. The
increase in our selling, general and administrative expenses was due to the
inclusion of the operations of Incentra of CA and PWI for the entire quarter in
2006.
During the three months ended March 31, 2006 and 2005, our results were
breakeven on an adjusted EBITDA(1) basis. Results for the three months ended
March 31, 2006 on an adjusted EBITDA basis include the add back of the $1.2
million loss on the early extinguishment of debt related to the 2005 Facility
and $427,000 of non-cash compensation expense following the adoption of SFAS
123R effective January 1, 2006. Results for the first quarter of 2005 on an
adjusted EBITDA basis included a gain of approximately $341,000 due to the
revaluation of a derivative warrant liability.
- ------------------------------
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 our past financings that, when excluded, we
believe produces more meaningful operating information. EBITDA also excludes
depreciation and amortization expenses, which are significant when compared to
such levels prior to the acquisition of MSI. 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 net loss before deemed
dividends and accretion on preferred stock is set forth below.
EBITDA Reconciliation
All amounts in (000's)
FOR THE THREE MONTHS ENDING MARCH 31,
2006 2005
------- -------
Net loss before deemed dividends
and accretion on preferred stock $(3,636) (2,348)
Depreciation and amortization 1,261 1,285
Taxes 94 318
Interest (cash portion) 332 77
Interest (non-cash portion) 297 462
------- -------
EBITDA (1,652) (206)
Loss on early extinguishment of debt 1,232 --
Non-cash stock based compensation 427 156
Referral fees -- 43
------- -------
EBITDA, as adjusted $ 7 $ (7)
======= =======
We continue to leverage our unique intellectual property by taking
advantage of our position as a leading provider of archive software solutions.
We continue to expand our product and service offerings in an effort to position
our company as a provider of a wide range of services and products to the
broadcast and media markets and to further solidify our leading market position.
We also continue to increase the number of products we have available for resale
to our customers both directly and through existing channel partners. We have
increased our expenditures for sales and marketing initiatives to meet an
increasing volume of digital archive implementations worldwide. We introduced
the sales of managed services along with our sales of storage products and
professional services directly to enterprise customers. We also believe we can
increase our sales of managed services by introducing these services to the
customers of our acquired businesses. We believe our professional services
business will be enhanced as we leverage our engineering resources across our
entire customer base.
RESULTS OF OPERATIONS - THREE MONTHS ENDED MARCH 31, 2006 COMPARED TO THE THREE
MONTHS ENDED MARCH 31, 2005
Our unaudited condensed consolidated financial statements as of March
31, 2006 and for the quarter then ended have been prepared on a going concern
basis, which contemplates the realization of assets and settlements of
liabilities and commitments in the normal course of business. Our audited
consolidated financial statements for the year ended December 31, 2005 were also
prepared on a going concern basis. In our Annual Report on Form 10-KSB for the
year ended December 31, 2005, the Report of our Independent Registered Public
Accounting Firm includes an explanatory paragraph that describes substantial
doubt about our ability to continue as a going concern as a result of the
possibility that substantially all of our long term debt may be accelerated due
to a dispute with a creditor as discussed in Notes 4(A) and 6(E) to our
unaudited condensed consolidated financial statements.
REVENUE. Total revenue for the three months ended March 31, 2006 increased $6.9
million, or 115%, to $12.9 million compared to total revenue of $6.0 million for
the three months ended March 31, 2005. This increase was attributable to the
additional revenues of $1.7 million resulting from increased sales in our
broadcast division and $5.3 million related to the inclusion of the operating
results of Incentra of CA and PWI in the full period, which increases were
offset by a reduction $0.1 million in managed service revenues. Revenue from the
sale of our products increased to $9.5 million compared to revenue of
approximately $3.2 million for the comparable prior year period. Revenue from
the delivery of our services increased $0.6 million to $3.4 million compared to
$2.8 million for the comparable prior year period. On a pro forma basis assuming
that the acquisitions of Incentra of CA and PWI occurred on January 1, 2005,
revenue for the three months ended March 31, 2006 decreased $3.5 million, or
22%, to $12.9 million due to lower sales of third-party product sales for
Incentra of CA and PWI of $4.9 million, lower services revenues for Incentra of
CA resulting from the loss of a large customer representing $0.6 million of
total revenues for the prior period and slightly lower service revenues for MSI
of $0.1 million. These decreases were offset by increases in revenues generated
by our broadcast division of $1.7 million and higher services revenues for PWI
of $0.3 million.
For the quarter ended March 31, 2006, a significant portion of our
revenues was derived from the European and Asian geographic markets. During that
period, aggregate revenues from customers located in Europe or Asia amounted to
$4.1 million, or 32% of total revenue, while revenues from customers located in
North America totaled $8.8 million, or 68% of total revenue. For the quarter
ended March 31, 2005, revenues from customers located in Europe and Asia
amounted to $3.0 million, or 50% of total revenue, while revenues from customers
located in North America totaled $3.0 million, or 50% of total revenue.
GROSS MARGIN. Total gross margin for the three months ended March 31, 2006
increased $2.2 million to $5.1 million, or 40% of total revenue, as compared
to gross margin of $2.9 million, or 49% of total revenue, for the comparable
prior year period. The decline in gross margin as a percentage of revenue was
due to increased sales of third-party products at lower gross margins, which
offset higher margins on the sales of our software and service solutions.
Product gross margin for the three months ended March 31, 2006 totaled $4.1
million, or 43% of product revenue. Service gross margin for the three months
ended March 31, 2006 totaled $1.0 million, or 30% of service revenue. On a pro
forma basis, gross margin for the three months ended March 31, 2006 increased
$0.6 million due to the mix of higher-margin broadcast product sales.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative ("SG&A") expenses for the three months ended March 31, 2006
increased by approximately $2.0 million to $6.0 million from $4.0 million for
the comparable prior year period. SG&A expenses included $4.5 million in
salaries and related benefits for employees not directly related to the
production of revenue, $0.5 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 $4.0 million for the comparable prior year
period included $2.6 million in salaries and related benefits for employees not
directly related to the production of revenue, $0.5 million in general office
expenses, $0.2 million in travel related costs, $0.5 million in professional
fees and $0.2 million of facilities costs. The increase for the three months
ended March 31, 2006 was due to an additional $1.5 million of SG&A expenses
relating to Incentra of CA and PWI as a result of the inclusion of those
operations for the entire quarter in 2006, an increase of $0.2 million in
salaries related to the broadcast business and an increase in employee
headcount. Also included in the 2006 increase in SG&A expenses was an increase
of $0.3 million related to the adoption of SFAS 123R and the recording of
additional non-cash compensation expense. On a pro forma basis, SG&A expenses
for the three months ended March 31, 2006 increased $0.4 million, primarily due
to the increase of non-cash compensation expense related to the adoption of SFAS
123R.
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 for each of the three months ended March 31, 2006 and
2005, of which approximately $0.5 million and $0.4 million was included in cost
of revenue for the three-month periods ending March 31, 2006 and 2005,
respectively.
OPERATING LOSS. During the three months ended March 31, 2006, we incurred a loss
from operations of $1.6 million as compared to a loss from operations of $1.9
million for the three months ended March 31, 2005. This decrease in operating
loss was primarily the result of the increase in gross margin of approximately
$2.2 million, offset in part by an increase in SG&A expenses of approximately
$2.0 million.
LOSS ON EARLY EXTINGUISHMENT OF DEBT. Refinancing of the 2005 Facility in the
first quarter of 2006 was accounted for as an early extinguishment of debt. A
loss of $1.2 million was recorded, which included $375,000 for an early
termination fee and $107,500 in costs associated with the refinancing. No
similar refinancing occurred in the first quarter of 2005.
INTEREST EXPENSE. Interest expense was $0.6 million for the three months ended
March 31, 2006 compared to $0.6 million for the three months ended March 31,
2005.
OTHER INCOME AND EXPENSE. Other expense was approximately $60,000 for the three
months ended March 31, 2006 compared to other income of approximately $367,000
for the three months ended March 31, 2005. Other income of $0.4 million for 2005
included $0.3 million of income resulting from the reassessment of the value of
contracts recorded under EITF 00-19 for outstanding warrants and $0.1 million of
investment income from leased equipment to customers and gains from sales of
fixed assets.
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 March 31, 2006 and 2005 were
minimal for each period.
INCOME TAX EXPENSE. We incurred income tax expense for the three months ended
March 31, 2006 of $0.1 million compared to $0.3 million for comparable period in
2005. This expense was entirely represented by non-cash income tax expense
related to our French subsidiary, Front Porch Digital International, SAS, and
any liability otherwise payable was offset by the utilization of the
subsidiary's deferred tax assets during the period.
NET LOSS APPLICABLE TO COMMON SHAREHOLDERS. During the three months ended March
31, 2006, we incurred a net loss applicable to common shareholders of $4.3
million as compared to a net loss applicable to common shareholders of $3.0
million for the three months ended March 31, 2005. The increase in net loss for
the three months ended March 31, 2006 was primarily due to an increase in
interest expense.
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 2006, we had $0.5 million of cash and cash equivalents.
Issuance of convertible debt and equity securities have been a principal source
of liquidity for us.
On May 13, 2004, we consummated a private placement pursuant to which
we issued to Laurus Master Fund Ltd ("Laurus") a secured convertible term note
due May 13, 2007 in the principal amount of $5.0 million (the "2004 Note"), and
a common stock purchase warrant entitling the noteholder to purchase 443,500
shares of our common stock. Subsequent to that date, the note and other terms
related to the indebtedness have been amended on several occasions. On February
6, 2006 we entered into an Amendment and Deferral Agreement (the "Amendment and
Deferral Agreement") with Laurus amending the 2004 Note. Pursuant to the
Amendment and Deferral Agreement, the monthly principal amount due Laurus under
the 2004 Note for each of January, February, March, April, May and June 2006,
equal to an aggregate of $952,495, is deferred until May 13, 2007. Scheduled
payments will resume of July 1, 2006.
On June 30, 2005, we entered into a Security Agreement with Laurus
pursuant to which Laurus provided us a $9 million revolving, convertible credit
facility. The outstanding principal amount under this facility was paid off on
February 6, 2006 in connection with our execution of a new security agreement
with Laurus pursuant to which Laurus provided us a non-convertible revolving
credit facility of up to $10 million (the "2006 Facility"). The term of the 2006
Facility is three years and borrowings under the 2006 Facility accrue interest
on the unpaid principal and interest at a rate per annum equal to the "prime
rate" published in The Wall Street Journal from time to time, plus 1%, subject
to a floor of seven percent (7%).
In connection with the 2006 Facility, we executed in favor of Laurus a
secured non-convertible revolving note in the principal amount of $10 million
(the "2006 Revolver Note"). Interest on borrowings under the 2006 Revolver Note
is payable monthly on the first day of each month during the term of the 2006
Revolver Note, commencing on March 1, 2006. All outstanding principal amounts
are due and payable on February 6, 2009. The minimum amount available to us
until April 30, 2006 was $6.5 million. Thereafter, the maximum principal amount
outstanding under the 2006 Revolver Note cannot exceed 90% of the combined
eligible accounts receivable of our company and all our U.S. subsidiaries.
On March 31, 2006, we consummated a private placement pursuant to which
we issued a secured term note due May 31, 2009 in the principal amount of
$1,750,000 (the "2006 Term Note") and a secured convertible term note due May
31, 2009 in the principal amount of $1,500,000 (the "2006 Convertible Note"). In
connection with the issuance of the 2006 Term Note and 2006 Convertible Note, we
issued a common stock purchase warrant entitling Laurus to purchase 417,857
shares of common stock (the "2006 Warrant") at $0.001 per share. Funding of
$3.25 million under the 2006 Term note and the 2006 Convertible Note was
completed on April 13, 2006 and was used to fund part of the cash portion of the
purchase price of our acquisition of NST.
As of March 31, 2006, we had current assets of $12.0 million. These
assets were primarily derived from our operations in 2006 and from our
acquisitions of Incentra of CA and PWI. Long-term assets of $24.2 million
consisted of $12.9 million of intangible assets resulting from the acquisitions
of MSI, Incentra of CA and PWI, $5.9 million of goodwill resulting from the
acquisitions of Incentra of CA and PWI, $2.4 million of property and equipment,
$2.3 million of software development costs and $0.7 million of other assets,
which consisted of $0.5 million of deferred financing costs and $0.2 million of
deposits, prepaid expenses and other receivables.
Current liabilities of $26.3 million at March 31, 2006 consisted of
$8.5 million of accounts payable; $2.3 million of deferred revenue, which
consisted of billings in excess of revenue recognized, deposits and progress
payments received on engagements currently in progress; $4.5 million of accrued
expenses; and $11.0 of current portion of notes payable, other long term
obligations, and capital leases.
Our working capital deficit was $14.3 million as of March 31, 2006,
which included the outstanding principal balance on the 2006 Facility of $5.3
million, net of debt discount of $1.2 million, which was classified as a current
liability as a result of the credit facility containing a lockbox arrangement
which requires all receipts to be swept daily to reduce borrowings outstanding
under the credit facility, and a subjective acceleration clause, as described in
Note 6(C) to the unaudited condensed consolidated financial statements. Also
included in the deficit was $1.3 million attributable to the reclassification of
the promissory note issued to a former owner of Incentra of CA to current
liabilities due to a default on such note and $2.4 million (net of discount) on
the Laurus Note due to cross default provisions with other long-term
indebtedness, as described in Notes 6(A) and 6(E) in the notes to unaudited
condensed consolidated financial statements as of March 31, 2006.
We used net cash of $0.2 million in operating activities during the
three months ended March 31, 2006, primarily as a result of the net loss
incurred during the period. We used net cash of $0.9 million in investing
activities during the three months ended March 31, 2006, of which $0.6 million
was used primarily to purchase or develop computer software and equipment.
Financing activities provided net cash of $0.5 million during the three months
ended March 31, 2006 primarily from the new Laurus financing. Repayment of
capital leases, long-term obligations and notes payable of $5.3 million was
offset by borrowings of $5.4 million under the 2006 Facility and $0.4 under the
lease line of credit.
As described in Note 6(E) to the condensed consolidated financial
statements, we are currently in default of the STAR Note and in the event the
outcome of our current arbitration proceeding is unfavorable, it is possible
that the full outstanding balance of the STAR Note could be accelerated. We do
not have the cash available to pay such amount and, in such event, we could
require additional financing to meet our obligations. There can be no assurances
that we will be able to obtain additional funding when needed, or that such
funding, if available, will be obtainable on terms acceptable to us. In the
event that our operations do not generate sufficient cash flow, or we cannot
obtain additional funds if and when needed, we may be forced to curtail or cease
our activities, which would likely result in the loss to investors of all or a
substantial portion of their investment.
We are still in the early stages of executing our business strategy,
have completed three significant acquisitions and expect to begin numerous new
acquisition engagements during the next 12 months. Although we are experiencing
success in the deployment of our marketing strategy for the sale and delivery of
our DIVArchive and other software solutions, continuation of this success is
contingent upon several factors, including the availability of cash resources,
the prices of our products and services relative to those of our competitors,
and general economic and business conditions, among others.
Our management believes our cash and cash equivalents and borrowings
available from the 2006 Facility, will provide us with sufficient capital
resources to fund our operations, debt service requirements, and working capital
needs for the next 12 months. There can be no assurances that we will be able to
obtain additional funding when needed, or that such funding, if available, will
be obtainable on terms acceptable to us. In the event that our operations do not
generate sufficient cash flow, or we cannot obtain additional funds if and when
needed, we may be forced to curtail or cease our activities, which would likely
result in the loss to investors of all or a substantial portion of their
investment.
Our actual financial results may differ materially from our stated plan
of operations. Factors that may cause a change from our plan of operations to
vary, include, without limitation, decisions of our management and board of
directors not to pursue our 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 expenditures and extend vendor
payments for additional cash flow flexibility.
We expect capital expenditures to be approximately $2.0 million and
capitalized software development costs to be approximately $1.6 million during
the 12-month period ended March 31, 2007. It is expected that our principal uses
of cash will be for working capital, to finance capital expenditures and for
other general corporate purposes, including financing the expansion of the
business and implementation of our sales and marketing strategy. The amount of
spending in each respective area is dependent upon the total capital available
to us.
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
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. During the course of the audit of our
consolidated financial statements for the year ending December 31, 2005, we
discovered that we incorrectly accounted for goodwill and changes to our
additional paid-in capital at March 31, 2005 in connection with two business
acquisitions recorded in the first quarter of 2005. The incorrect amounts were
subsequently included in the balance sheets included in our Form 10-QSB filings
for quarters ending June 30, 2005, and September 30, 2005. There was no impact
on our interim Statements of Operations and Cash Flows as a result of these
errors. The Audit Committee of our Board of Directors has directed us to create
a formal review process covering acquisition accounting and to include a
Statement of Changes in Shareholders' Deficit and Comprehensive Loss with future
filings on Form 10-QSB. We believe that these measures implemented in April 2006
fully address the accounting and financial reporting concerns associated with
this matter.
Except for the above matter, 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 2006
that have materially affected, or are reasonably likely to materially affect,
our internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
STAR NOTE DEFAULT
We are engaged in an arbitration proceeding to resolve a dispute with
one of our creditors that, if resolved unfavorably, would have a material
adverse affect on our liquidity and financial condition. The hearing phase of
the arbitration proceeding was completed in April 2006, and both parties have
submitted their proposed findings of fact and conclusions of law to the
arbitrator. A ruling from the arbitrator is expected by June 2006. In connection
with our acquisition of STAR (now known as Incentra of CA) in February 2005, we
issued to Alfred Curmi, the principal stockholder of STAR, a promissory note
(the "STAR Note") in the principal amount of $2.5 million that is payable in ten
installments and matures on August 1, 2007. On August 1, 2005, we elected to
cease making payments to Mr. Curmi due under the STAR Note after we identified
significant required post-closing adjustments to the purchase price for the
assets of STAR and, consequently, the principal amount of the STAR Note. On
August 16, 2005, we received a demand for arbitration from legal counsel to Mr.
Curmi. As of December 31, 2005, we have reclassified the balance of $2.4 million
on the STAR Note to current liabilities due to the default and the possibility
that the arbitrator may rule in favor of Mr. Curmi in such proceeding. While
management does not believe the debt will be paid within one year of the balance
sheet date, the reclassification on the balance sheet was made as the debt is
now callable. We do not have the cash available to pay such amount and, in such
event, we would require additional financing to meet our obligation. There can
be no assurance that we would be able to obtain additional funding when needed,
or that such funding, if available, will be obtainable on terms acceptable to
us. In the event our operations do not generate sufficient cash flow, or we
cannot obtain additional funds if and when needed, we may be forced to curtail
or cease our activities, which would likely result in the loss to investors of
all or a substantial portion of their investment. The event of default on the
STAR Note created an event of default of certain provisions of our various
promissory notes with Laurus as described in the notes to our unaudited
condensed consolidated financial statements.
ITEM 5. OTHER INFORMATION
On May 4, 2006, our board of directors approved and adopted the
Incentra Solutions, Inc. 2006 Stock Option Plan (the "Plan"), which provides for
the granting of options to key employees, officers and certain individuals to
purchase shares of the our common stock. We currently have reserved 1,750,000
shares of common stock for issuance under the Plan. The Plan has a term of ten
years and provides for the grant of "incentive stock options" within the meaning
of Section 422 of the Internal Revenue Code of 1986, as amended and nonstatutory
stock options. Options granted under the plan may not have a term of more than a
ten-year period (five years in the case of incentive stock options granted to
employees who hold more than ten percent (10%) of the voting power of the
Company's common stock). Subject to the terms of any award agreement, options
generally terminate three months after the termination of employment, except in
the case of termination for cause or upon death or disability. We plan to
register under the Securities Act of 1933, the shares of our common stock
issuable upon exercise of the options granted pursuant to the Plan.
ITEM 6. EXHIBITS.
The exhibits required by this item are listed on the Exhibit Index attached
hereto.
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: May 15, 2006 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)
EXHIBIT INDEX
10.1 Incentra Solutions, Inc. 2006 Stock Option Plan, dated as of May 4, 2006.
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.