Conformed
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the Quarterly Period Ended June 30, 2001.
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the Transition Period from ____________to________.
Commission File Number: 0-26494
GSE SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware 52-1868008
(State or other jurisdiction of (I.R.S. Employer Identification No)
incorporation or organization)
9189 Red Branch Road, Columbia Maryland, 21045
(Address of principal executive office and zip code)
Registrant's telephone number, including area code: (410) 772-3500
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No ____
As of August 2, 2001, there were 5,193,527 shares of the Registrant's common
stock outstanding.
GSE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
INDEX
PAGE
PART I FINANCIAL INFORMATION 3
Item 1 Financial Statements:
Consolidated Balance Sheets as of June 30, 2001 and December 31, 2000 3
Consolidated Statements of Operations for the Three and Six Months Ended June 30, 4
2001 and June 30, 2000
Consolidated Statements of Comprehensive Income for the Three and Six Months Ended 5
June 30, 2001 and June 30, 2000
Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2001 and 6
June 30, 2000
Notes to Consolidated Financial Statements 7
Item 2 Management's Discussion and Analysis of Results of Operations and Financial Condition 14
Item 3 Quantitative and Qualitative Disclosure About Market Risk 20
PART II . OTHER INFORMATION 21
Item 1 Legal Proceedings 21
Item 2 Changes in Securities and Use of Proceeds 21
Item 3 Defaults Upon Senior Securities 21
Item 4 Submission of Matters to a Vote of Security Holders 21
Item 5 Other Information 21
Item 6 Exhibits and Reports on Form 8-K 21
SIGNATURES 22
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
Unaudited
June 30, 2001 December 31, 2000
ASSETS
Current assets:
Cash and cash equivalents $ 607 $ 1,465
Restricted cash 163 30
Contract receivables 13,850 14,489
Inventories 1,537 1,587
Prepaid expenses and other current assets 1,863 2,520
Deferred income taxes 677 277
_________ _______
Total current assets 18,697 20,368
Investment in Avantium Technologies B.V. 7,503 2,895
Property and equipment, net 1,797 2,299
Software development costs, net 4,241 5,067
Goodwill, net 2,718 2,996
Deferred income taxes 847 847
Restricted cash 340 503
Other assets 703 974
__________ _______
Total assets $ 36,846 $ 35,949
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt $ 1,967 $ 2,347
Accounts payable 4,733 5,669
Accrued expenses 1,837 2,115
Accrued compensation and payroll taxes 1,939 1,940
Billings in excess of revenue earned 2,237 1,366
Accrued warranty reserves 632 462
Other current liabilities 1,497 947
________ _______
Total current liabilities 14,842 14,846
Long-term debt 10,739 11,840
Accrued warranty reserves 415 550
________ _______
Total liabilities 25,996 27,236
Stockholders' equity:
Common stock $.01 par value, 8,000,000 shares authorized, shares issued
and outstanding 5,193,527 in 2001 and in 2000 52 52
Additional paid-in capital 22,424 22,230
Retained earnings (deficit) - at formation (5,112) (5,112)
Retained earnings (deficit) - since formation (5,373) (7,555)
Accumulated other comprehensive loss (1,141) (902)
Total stockholders' equity 10,850 8,713
Total liabilities and stockholders' equity $ 36,846 $ 35,949
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(Unaudited)
Three months Six months
ended June 30, ended June 30,
2001 2000 2001 2000
Contract revenue $ 11,845 $ 13,300 $ 24,323 $ 28,424
Cost of revenue 8,563 10,314 18,069 19,437
Gross profit 3,282 2,986 6,254 8,987
Operating expenses
Selling, general and administrative 2,478 3,966 5,298 8,395
Depreciation and amortization 340 431 701 869
Total operating expenses 2,818 4,397 5,999 9,264
Operating income (loss) 464 (1,411) 255 (277)
Gain on sale of assets - - 3,273 -
Interest expense, net (220) (129) (452) (320)
Other income, net 109 63 133 21
Income (loss) before income taxes 353 (1,477) 3,209 (576)
Provision (benefit) for income taxes (115) (575) 1,027 (210)
Net income (loss) $ 468 $ (902) $ 2,182 $ (366)
Basic earnings (loss) per common share $0.09 $ (0.17) $ 0.42 $ (0.07)
Diluted earnings (loss) per common share $0.09 $ (0.17) $ 0.42 $ (0.07)
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(Unaudited)
Three months Six months
ended June 30, ended June 30,
2001 2000 2001 2000
Net income (loss) $ 468 $ (902) $ 2,182 $ (366)
Foreign currency translation adjustment (97) (22) (239) 141
Comprehensive income (loss) $ 371 $ (924) $ 1,943 $ (225)
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
Six months
ended June 30,
2001 2000
Cash flows from operating activities:
Net income (loss) $ 2,182 $ (366)
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,778 1,949
Gain on sale of assets (3,273) -
Non-monetary consideration received for software licensed to
Avantium Technologies B.V. - (2,895)
Deferred income taxes (400) (288)
Contract receivables 639 1,648
Inventories, prepaid expenses and other assets 59 716
Accounts payable, accrued compensation and accrued expenses (2,117) (828)
Billings in excess of revenues earned 871 (178)
Accrued warranty reserves 35 49
Other liabilities 495 (661)
Net cash provided by (used in) operating activities 269 (854)
Cash flows from investing activities:
Capital expenditures (187) (220)
Capitalized software development costs (302) (1,017)
Net cash used in investing activities (489) (1,237)
Cash flows from financing activities:
Proceeds from issuance of note payable to stockholder 3,350 -
(Restrictions) releases of cash as collateral under line of credit, net 30 -
Increase (decrease) in borrowings under lines of credit (4,005) 1,754
Proceeds from issuance of common stock - 541
Other financing activities, net 3 (400)
Net cash provided by (used in) financing activities (622) 1,895
Effect of exchange rate changes on cash (16) (45)
Net decrease in cash and cash equivalents (858) (241)
Cash and cash equivalents at beginning of period 1,465 2,695
Cash and cash equivalents at end of period $ 607 $ 2,454
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Six Months ended June 30, 2001 and 2000
(Unaudited)
1 Basis of Presentation
The consolidated financial statements included herein have been
prepared by GSE Systems, Inc. (the "Company") without independent audit.
In the opinion of the Company's management, all adjustments and
reclassifications of a normal and recurring nature necessary to present
fairly the financial position, results of operations and cash flows for
the periods presented have been made. 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. These consolidated
financial statements should be read in conjunction with the consolidated
financial statements and notes thereto included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2000 filed with the
Securities and Exchange Commission on April 2, 2001.
2. Basic and Diluted Earnings (Loss) Per Common Share
Basic earnings (loss) per share is based on the weighted average
number of outstanding common shares for the period. Diluted earnings
(loss) per share adjusts the weighted average shares outstanding for the
potential dilution that could occur if stock options or warrants were
exercised or converted into common stock. The number of common shares
and common share equivalents used in the determination of basic and
diluted earnings (loss) per share were as follows:
Three months Six months
ended June 30, ended June 30,
2001 2000 2001 2000
Weighted average shares outstanding - Basic 5,193,527 5,192,794 5,193,527 5,188,534
Weighted average shares outstanding - Diluted 5,252,527 5,192,794 5,221,215 5,188,534
The difference between the basic and diluted number of weighted
average shares outstanding for the quarters ended June 30, 2001
represents dilutive stock options and warrants to purchase shares of
common stock computed under the treasury stock method, using the average
market price during the period. Common stock equivalents are not
considered if their effect is dilutive.
3. Inventories
Inventories are stated at the lower of cost, as determined by the
average cost method, or market. Obsolete or unsaleable inventory is
reflected at its estimated net realizable value. Inventories consist of
the following:
(in thousands) June 30, December 31,
2001 2000
Raw materials $ 1,100 $ 1,084
Service parts 437 503
_________ ________
Total inventories $ 1,537 $ 1,587
4. Software Development Costs
Certain computer software development costs are capitalized in
the accompanying consolidated balance sheets. Capitalization of
computer software development costs begins upon the establishment of
technological feasibility. Capitalization ceases and amortization of
capitalized costs begins when the software product is commercially
available for general release to customers. Amortization of capitalized
computer software development costs is included in cost of revenue and
is determined using the straight-line method over the remaining
estimated economic life of the product, not to exceed five years.
Software development costs capitalized were $150,000 and $570,000
for the three months ended June 30, 2001 and 2000, respectively. Total
amortization expense was $551,000 and $544,000 for the three months
ended June 30, 2001 and 2000, respectively.
For the six months ended June 30, 2001 and 2000, software
development costs capitalized were $302,000 and $1,017,000,
respectively. Total amortization expense was $1,078,000 and $1,080,000
for the six months ended June 30, 2001 and 2000, respectively.
5. Investment in Avantium International B.V.
On February 24, 2000, the Company licensed certain of its simulation
software products to Avantium International B.V. ("Avantium") in
exchange for 251,501 shares of Avantium preferred stock, valued at $2.5
million, and 352,102 shares of Avantium common stock, valued at
$349,000. The software license, which is perpetual in nature, gives
Avantium the right to use the software in the development of new
software products. Each share of preferred stock is convertible into
common stock. Subject to certain restrictions, in the event that
Avantium has not conducted an initial public offering (or been
purchased) within five years, the Company and certain other holders of
preferred shares may, at their option, have their shares redeemed by
Avantium, for the greater of (i) the original purchase price plus 8%
interest compounded annually plus any accrued and unpaid dividends
whether or not declared, or (ii) the fair market value of the shares on
an as-if-converted-into-common-shares-basis plus any accrued and unpaid
dividends.
Avantium was formed to develop high-speed experimentation and
simulation ("HSE&S") technologies for application in new product and
process development in pharmaceutical, petrochemical, fine chemical,
biotechnology and polymers industries. Avantium expects to develop HSE&S
technologies through in-house development and contract research at
leading universities, hardware developers and informatics companies.
Avantium has various investors, including Shell International Chemical,
SmithKline Beecham, W.R. Grace, three major European universities and
two venture capital firms.
During the year ended December 31, 2000, the Company recognized
software-licensing revenue of $2.9 million based on the fair value of
the consideration received from Avantium. The fair value was established
based on cash paid by other investors for their respective preferred and
common stock interests in Avantium. The Company has delivered all
elements of the software and has no other obligations to Avantium, other
than standard warranty. The Company will account for its investment in
Avantium using the cost method of accounting based on management's
conclusion that the Company does not have significant influence with
respect to the operations of Avantium. During the year ended December
31, 2000, the Company also received and completed an additional $2.9
million contract to make certain improvements and enhancements to the
software on a best efforts basis for Avantium. The rates and margins in
the contract are comparable to those the Company earns performing
services for its existing customers.
As a result of the experience with Avantium in 2000, the Company
concluded that a combination of the relevant interests of the two
companies would significantly increase the potential of both
organizations. In addition, focusing the technical and marketing
resources of Avantium and the GSE VirtualPlant team would produce
significant cost savings. Accordingly, on March 6, 2001, the Company
sold its VirtualPlant business to Avantium. Avantium purchased certain
fixed assets and intellectual property (including BatchCAD and
BatchWizard software products), obtained perpetual licenses to certain
GSE Process software products, and employed certain personnel in both
the US and the UK. GSE received 8% of Avantium's stock, thus increasing
its holdings in Avantium to approximately 19%. Avantium and GSE will
continue to work together in the marketplace and in product development
so that common clients will be able to use Avantium's VirtualPlant
technology to develop scalable products that will fit together at the
manufacturing level with GSE's process control and simulation products.
However, GSE is not obligated to provide any further support to
Avantium.
During the first quarter of 2001, the Company recognized a gain on
the sale of its VirtualPlant business of $3.3 million, before income
taxes. This gain was determined based on the estimated fair value of the
Avantium stock received, based on an independent appraisal, net of the
book value of the assets sold and the estimated costs to settle
severance with employees terminated from GSE and other transaction
expenses. GSE retains one seat on the supervisory board of Avantium.
However, management has concluded that such seat does not provide the
Company with significant influence. Accordingly, the Company will
account for its investment in Avantium using the cost method. If a
decline in fair value below cost is judged by management to be other
than temporary, the cost basis will be written down to fair value as a
new cost basis and the amount of the write-down will be included in
earnings as a realized loss. Any new cost basis derived in this manner
will not be changed for subsequent recoveries in fair value.
6. Long-term Debt
The Company has a $10.0 million bank line of credit (the "Credit
Facility") under which the Company and its subsidiaries, GSE Process
Solutions, Inc. and GSE Power Systems, Inc., are jointly and severally
liable as co-borrowers. The Credit Facility provides for borrowings to
support working capital needs and foreign letters of credit ($2.0
million sublimit). The line is collateralized by substantially all of
the Company's assets and provides for borrowings up to 85% of eligible
accounts receivable, 50% of eligible unbilled receivables and 40% of
eligible inventory (up to a maximum of $1.2 million). GP Strategies
Corporation, one of the Company's major stockholders, has provided a
limited guarantee totaling $1.8 million. The interest rate on this line
of credit is based on the bank's prime rate plus 0.75% (7.50% as of June
30, 2001), with interest only payments due monthly. At June 30, 2001,
the Company's available borrowing base was approximately $6.4 million,
of which approximately $5.3 million had been utilized. The Credit
Facility expires on March 23, 2003.
The Credit Facility requires the Company to comply with certain
financial ratios and precludes the Company from paying dividends and
making acquisitions beyond certain limits without the bank's consent. At
June 30, 2001, the Company was in compliance with the covenants.
In the fourth quarter of 2000, the Company issued a demand
promissory note to ManTech International Corporation ("ManTech"), one of
the Company's major stockholders, that allowed the Company to borrow up
to $1.8 million at an interest rate of prime plus one percent. The
promissory note was secured by the Company's pledge of its equity
interest in Avantium, but such security interest was subordinate to the
first lien thereon by the Company's bank. In the first quarter of 2001,
the Company borrowed an additional $550,000 from ManTech and the
promissory note was amended to increase the principal amount to $2.1
million. Subsequently, in the first quarter of 2001, and with ManTech's
approval, the Company issued a replacement promissory note in the amount
of $2.1 million to ManTech pursuant to which the Company's obligations
to ManTech became unsecured and the principal is payable over a two year
period, in equal installments, commencing April 1, 2004, with interest
payments to commence monthly on July 1, 2001. The note permits ManTech
to convert the principal into GSE convertible preferred stock at a
conversion rate of $100 per share. ManTech agreed to subordinate the
note to the Company's Credit Facility.
In 2000, ManTech had provided $1.8 million in standby letters of
credit to the bank as additional collateral for the Company's credit
facility. On April 6, 2001, ManTech agreed to allow the Company's bank
to draw upon the letters of credit, thus paying down a portion of the
Company's bank debt in exchange for additional subordinated debt in the
Company. Accordingly, the Company's promissory note to ManTech was
amended to increase the amount to $3.9 million. As permitted by the
note, ManTech elected to convert its debt into equity in the form of
convertible preferred stock at the conversion rate of $100 per share.
Thus, the Company will issue 39,000 shares of preferred stock to ManTech
in the third quarter 2001. The convertible preferred stock will have a
stated dividend rate of 6% per annum payable quarterly. Dividends will
accumulate if not paid quarterly and dividends will accrue at the stated
rate on any unpaid dividends. ManTech at its discretion shall have the
right to convert each share of convertible preferred stock into GSE
common stock at a purchase price of $2.645 per share at any time after a
one-year holding period from the date of issuance. At the end of the
third year from the date of issuance, the convertible preferred stock
automatically converts into GSE common stock. Prior to ManTech's
conversion of the convertible preferred stock to common stock, GP
Strategies has the option to acquire 50% of the convertible preferred
stock for $1,950,000.
On June 25, 2001, the Company issued an additional unsecured
promissory note to ManTech that allowed the Company to borrow up to $1.0
million at an interest rate of prime plus one percent. The note is
subordinated to the Company's Credit Facility. The note and accrued
interest may be repaid from the cash receipts of a public equity
offering (see Note 11, Subsequent Events). If the offering is not
completed, or does not provide sufficient cash to pay off the entire
promissory note and accrued interest, the principal is payable over a
two year period, in equal installments, commencing April 1, 2004, with
interest payments to commence monthly on January 1, 2002.
7. Letters of Credit
As of June 30, 2001, the Company was contingently liable for
approximately $503,000 under four letters of credit used as payment
bonds on contracts, all of which were secured by cash deposits
classified as restricted cash in the consolidated balance sheet.
8. Income Taxes
The Company's effective tax rate is based on its best current
estimate of its expected annual effective tax rate. The difference
between the statutory U.S. tax rate and the Company's effective tax rate
for the quarters ended June 30, 2001 and 2000 is primarily due to the
effects of foreign operations being taxed at different rates, state
income taxes and in 2001 the impact of deferred tax assets expected to
be realized in the current year which previously had not been recognized
by the Company as a result of a valuation allowance. As of June 30, 2001
and December 31, 2000, the aggregate deferred tax assets are recorded
net of valuation allowances of approximately $5.0 million and $5.4
million, respectively. For the six months ended June 30, 2001, the
Company reduced its valuation allowance by approximately $400,000. The
Company continues to evaluate the likelihood of realizing its remaining
deferred tax assets.
9. Segment Information
The Company's two reportable segments are its core business units
Process and Power. (The Company's VirtualPlant business is reported
under the Process segment.) The Company is primarily organized on the
basis of these two business units. The Company has a wide range of
knowledge of control and simulation systems and the processes those
systems are intended to improve, control and model. The Company's
knowledge is concentrated heavily in the process industries, which
include the chemicals, food & beverage, and pharmaceuticals fields, as
well as in the power generation industry. The Process business unit is
primarily engaged in process control and simulation in a variety of
commercial industries. Contracts typically range from three to nine
months. The Power business unit is primarily engaged in simulation for
the power generation industry, with the vast majority of customers being
in the nuclear power industry. Contracts typically range from 18 months
to three years.
The Company evaluates the performance of its business units
utilizing "Business Unit Contribution", which is substantially
equivalent to earnings before interest and taxes before allocating any
corporate expenses.
The table below presents information about the reportable segments:
(in thousands) Three months ended June 30, 2001 Six months ended June 30, 2001
Process Power Consolidated Process Power Consolidated
Contract revenue $ 4,162 $ 7,683 $ 11,845 $ 9,476 $ 14,847 $ 24,323
Business unit contribution $ 432 $ 915 $ 1,347 $ 275 $ 1,941 $ 2,216
Three months ended June 30, 2000 Six months ended June 30, 2000
Process Power Consolidated Process Power Consolidated
Contract revenue $ 5,241 $ 8,059 $ 13,300 $ 13,205 $ 15,219 $ 28,424
Business unit contribution $(1,993) $ 1,866 $ (127) $ (747) $ 2,776 $ 2,029
The Company sold its Belgian business in November 2000 and its
VirtualPlant business in March 2001 (see Note 5, Investment in Avantium
International B.V.). Whereas the Process segment contract revenues for
the three months ended June 30, 2001 included no revenues from these
divested businesses, the Process revenues for the three months ended
June 30, 2000 included revenues of $1.3 million. For the six months
ended June 30, 2001 and 2000, Process revenues included $507,000 and
$5.1 million, respectively, for theses two divested businesses. The
Process 2000 revenues also include $2.9 million from a software-license
sold to Avantium (see Note 5, Investment in Avantium International
B.V.).
Process business unit contribution for the three and six months
ended June 30, 2000 included a loss of $1.4 million and income of
$77,000, respectively, from the two divested businesses. In 2001, the
Process business unit contribution included a loss for VirtualPlant of
$471,000 prior to its sale in March 2001.
A reconciliation of segment business unit contribution to
consolidated income (loss) before taxes is as follows:
(in thousands) Three months Six months
ended June 30, ended June 30,
2001 2000 2001 2000
Segment business unit contribution $ 1,347 $ (127) $ 2,216 $ 2,029
Corporate expenses (774) (1,221) (1,828) (2,285)
Gain on disposition of assets - - 3,273 -
Interest expense, net (220) (129) (452) (320)
_______ _______ _______ ______
Income (loss) before income taxes $ 353 $ (1,477) $ 3,209 $ (576)
10. New Accounting Standards
Effective January 1, 2001, the Company adopted Financial Accounting
Standards No. 133, "Accounting for Derivative Instruments and Hedging
Activities," and No. 138 "Accounting for Certain Derivative Instruments
and Certain Hedging Activities." These statements require that an entity
recognize all derivatives as either assets or liabilities in the
statement of financial position and measure those instruments at fair
value. The adoption of these standards, including the valuation of
derivative instruments outstanding on the effective date, did not have a
material impact on the Company's consolidated financial statements.
On July 20, 2001, the FASB issued Statement No. 141, "Business
Combinations", and Statement No. 142, "Goodwill and Other Intangible
Assets". Statement 141 requires that all business combinations be
accounted for under a single method -- the purchase method. Use of the
pooling-of-interests method no longer is permitted. Statement 141
requires that the purchase method be used for business combinations
initiated after June 30, 2001. Statement 142 requires that goodwill no
longer be amortized to earnings, but instead be reviewed for impairment.
The amortization of goodwill ceases upon adoption of the Statement,
which for calendar year-end companies, will be January 1, 2002.
11. Subsequent Events
At a special shareholder's meeting on August 2, 2001, the Company's
shareholders approved an amendment to the Certificate of Incorporation
increasing GSE's authorized common stock by 10 million shares to a total
of 18 million shares. With this new allocation of common stock, the
Company intends to issue approximately 3.7 million shares of common as
follows: (a) 1,474,480 shares to cover the exchange of $3.9 million of
the ManTech subordinated debt into convertible preferred stock as
discussed above, and (b) 2,219,701 shares for a contemplated rights
offering to non-affiliate stockholders.
In connection with the contemplated rights offering, the Company has
initiated the process to prepare a registration statement (including a
prospectus). On May 30, 2001, the Company's board of directors approved
the pricing for the rights offering at 10% above the market price on
June 15, 2001. The market price on June 15, 2001 was $2.30 per share. A
10% premium equals a rights offering price of $2.53 per share, 5% below
the price per share of common stock issuable upon conversion of the
preferred stock to be issued to ManTech. If all shares expected to be
offered are sold, the estimated proceeds to GSE would be approximately
$5.6 million before the fees and expenses related to the offering. The
principal purposes of the offering are for repayment of a $1 million
loan from ManTech (see Note 6, Long-term Debt), working capital,
strategic acquisitions, capital expenditures and general corporate
purposes.
GSE SYSTEMS, INC. AND SUBSIDIARIES
FORM 10-Q
Six Months ended June 30, 2001 and 2000
Item 2. Management's Discussion and Analysis of Results of Operations and
Financial Condition
Cautionary Statement Regarding Forward-Looking Statements
This Form 10-Q contains certain "forward-looking statements" within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended, which are subject to the
safe harbors created by those Acts. These statements include the plans and
objectives of management for future operations, including plans and objectives
relating to the development of the Company's business in the domestic and
international marketplace. All forward-looking statements involve risks and
uncertainties, including, without limitation, risks relating to the Company's
ability to enhance existing software products and to introduce new products in a
timely and cost-effective manner, reduced development of nuclear power plants
that may utilize the Company's products, a long pay-back cycle from the
investment in software development, uncertainties regarding the ability of the
Company to grow its revenues and successfully integrate operations through
expansion of its existing business and strategic acquisitions, the ability of
the Company to respond adequately to rapid technological changes in the markets
for process control and simulation software and systems, significant
quarter-to-quarter volatility in revenues and earnings as a result of customer
purchasing cycles and other factors, dependence upon key personnel, the ability
of the Company to meet bank financial covenants and manage cash needs, and
general market conditions and competition. See "Risk Factors," in Part I of the
Company's Form 10-K for the year-ended December 31, 2000. The forward-looking
statements included herein are based on current expectations that involve
numerous risks and uncertainties as set forth herein, the failure of any one of
which could materially adversely affect the operations of the Company. The
Company's plans and objectives are also based on the assumptions that market
conditions and competitive conditions within the Company's business areas will
not change materially or adversely and that there will be no material adverse
change in the Company's operations or business. Assumptions relating to the
foregoing involve judgments with respect to, among other things, future
economic, competitive and market conditions and future business decisions, all
of which are difficult or impossible to predict accurately and many of which are
beyond the control of the Company. Although the Company believes that the
assumptions underlying the forward-looking statements are reasonable, any of the
assumptions could be inaccurate and there can, therefore, be no assurance that
the forward-looking statements included in this Form 10-Q will prove to be
accurate. In light of the significant uncertainties inherent in forward-looking
statements, any such information included herein should not be regarded as a
representation by the Company or any other person that the objectives and plans
of the Company will be achieved.
General Business Environment
GSE Systems, Inc. ("GSE Systems", "GSE" or the "Company") develops and
delivers business and technology solutions by applying process control,
simulation software, systems and services to the energy, process and
manufacturing industries worldwide. The Company's solutions and services assist
customers in improving quality, safety and throughput; reducing operating
expenses; and enhancing overall productivity.
Power Simulation Business
The Company's Power Simulation Business Unit ("Power") is continuing
its efforts to expand its leadership in nuclear simulation technology to the
fossil simulation marketplace. In the past year, GSE has released its "G-Suite"
software tools which target fossil simulation applications. These new tools
elevate the level of simulation beyond traditional training to allow the
operator to optimize plant performance. Following a concerted global marketing
effort, GSE has been awarded over $9 million of new orders for six fossil
simulators in the United States and India in the last twelve months, including
an award from American Electric Power in 2001 for two full-scope fossil training
simulators.
The deregulation of the electric power industry and the California
energy crisis have underscored the importance of efficient and reliable
operations of power stations. The use of simulation to address these issues has
resulted in new opportunities for GSE to improve the simulation fidelity of
existing simulators and the supply of new simulators around the world. While GSE
simulators are primarily utilized for power plant operator training, the uses
are expanding to include engineering, plant modification studies, and operation
efficiency improvements for both nuclear and fossil utilities. During plant
construction simulators are used to test control strategies and ensure on-time
start-up. After commissioning, the same tools can be used to increase plant
availability and optimize plant performance for the life of the facility.
President Bush's National Energy Policy encourages the improvement of
nuclear plant operating performance from 90%, the current level, to 92%. In the
second quarter of 2001, GSE released several products using advanced signal
analysis techniques to help nuclear plants achieve this increase in operating
performance. GSE's Pegasus Plant Surveillance and Diagnosis System(TM) helps
improve plant availability, safety and economy. Pegasus is a software package
for semi-automatic plant surveillance and diagnostics and enables site engineers
to perform detailed analysis for specified component faults, allowing the
identification of degraded performance and replacement of components before they
fail. SensBase(TM) provides comprehensive sensor test services, thus ensuring
that changes in transmitters and other instruments do not jeopardize the
function of the nuclear plant protection systems. BRUS(TM) , a noise analysis
program package, is a collection of signal analysis tools which allow users to
detect developing abnormalities in the plant.
Process Control Business
In order to return the Company's Process Control Business Unit
("Process") to profitability, the Company implemented a restructuring plan in
2000 that included personnel reductions, the outsourcing of Process'
manufacturing and assembly operations, and the November, 2000 sale of Process'
unprofitable European operations based in Belgium. The restructuring was
completed in the first quarter 2001 with the sale of the Business Unit's
VirtualPlant technology and assets to Avantium International BV ("Avantium") in
exchange for Avantium stock. Avantium and GSE expect to continue to work
together in the marketplace and in product development so that common clients
will be able to use Avantium's VirtualPlant technology to develop scalable
products that will fit together at the manufacturing level with GSE's process
control and simulation products, thus speeding up market introduction and
reducing the overall life cycle costs.
Process released the latest version, 10.2, of its D/3 Distributed
Control System(TM) software in December 2000. The new release furthers GSE's
strategy of providing an open system able to seamlessly communicate with a
variety of third-party hardware and software. By allowing maximum flexibility in
selection of Input-Output systems, customers can take advantage of the latest
control technology without costly replacement of their plant hardware.
To expand within its traditional customer base, and gain new customers,
we have embarked upon a program to modify our process control module (PCM) to
increase its operating speed and reduce its manufacturing costs. This will allow
us to bridge the cost gap between programmable logic controllers (PLCs) and the
distributed control systems while providing the increased performance of a
full-function distributed control system. Products based upon these
modifications will start to be released in the fourth quarter of 2001 and
continue into 2002.
Results of Operations
The following table sets forth the results of operations for the
periods presented expressed in thousands of dollars and as a percentage of
revenues:
(in thousands) Three months ended June 30, Six months ended June 30,
2001 % 2000 % 2001 % 2000 %
Contract revenue $ 11,845 100.0 % $ 13,300 100.0 % $ 24,323 100.0 % $28,424 100.0%
Cost of revenue 8,563 72.3 % 10,314 77.5 % 18,069 74.3 % 19,437 68.4%
Gross profit 3,282 27.7 % 2,986 22.5 % 6,254 25.7 % 8,987 31.6%
Operating expenses:
Selling,general and administrative 2,478 20.9 % 3,966 29.8 % 5,298 21.8 % 8,395 29.5%
Depreciation and amortization 340 2.9 % 431 3.2 % 701 2.9 % 869 3.1%
Total operating expenses 2,818 23.8 % 4,397 33.1 % 5,999 24.7 % 9,264 32.6%
Operating income (loss) 464 3.9 % (1,411) (10.6)% 255 1.0 % (277) (1.0)%
Gain on sale of assets - 0.0 % - 0.0 % 3,273 13.5 % - 0.0 %
Interest expense, net (220) (1.9)% (129) (1.0)% (452) (1.9)% (320) (1.1)%
Other income, net 109 0.9 % 63 0.5 % 133 0.5 % 21 0.1%
Income (loss) before income taxes 353 3.0 % (1,477) (11.1)% 3,209 13.2 % (576) (2.0)%
Provision (benefit) for income taxes (115) (1.0)% (575) (4.3)% 1,027 4.2 % (210) (0.7)%
Net income (loss) $ 468 4.0 % $ (902) (6.8)% $ 2,182 9.0 % $ (366) (1.3)%
Contract Revenue. Revenue for the three and six months ended June 30,
2001 amounted to $11.9 million and $24.3 million, respectively, as compared with
revenues of $13.3 million and $28.4 million for the three and six months ended
June 30, 2000.
The Process business unit's revenue was $4.2 million for the second
quarter 2001, compared with $5.2 million for the second quarter 2000; revenue
for the six months ended June 30, 2001 and 2000 was $9.5 million and $13.2
million, respectively. The Company sold its unprofitable Belgian subsidiary, GSE
Process Solutions N.V., on November 30, 2000 to Newton Integrated Services B.V.
of the Netherlands, and sold its VirtualPlant technology and assets on March 6,
2001 to Avantium. Whereas revenues for the three months ended June 30, 2001
included no revenues from these divested businesses, the revenues for the three
months ended June 30, 2000 included revenues of $1.3 million. For the six months
ended June 30, 2001 and 2000, Process revenues included $507,000 and $5.1
million, respectively, for these two divested businesses. Included in the 2000
revenues was $2.9 million from the sale of licenses for five of GSE's software
products to Avantium International B.V., in exchange for an equity interest in
Avantium (see Note 5, Investment in Avantium International B.V. in the Notes to
Consolidated Financial Statements). Excluding the revenues for these divested
businesses, the Process business unit's revenues increased $300,000, or 7.7%, in
the second quarter 2001 as compared with the prior year, and increased $900,000,
or 11.1%, for the six months ended June 30, 2001 as compared to the same period
in the prior year.
The Power business unit revenues decreased 4.7% in the second
quarter, from $8.1 million in 2000 to $7.7 million in 2001. Revenue for the six
months ended June 30, 2001 and 2000 was $14.8 million and $15.2 million,
respectively.
Gross Profit. Gross profit totaled $3.3 million (27.7% of revenue) for
the quarter ended June 30, 2001, as compared with $3.0 million (22.5% of
revenue) for the same period in 2000. The increase in gross margin as a
percentage of revenue is largely due to the restructuring of the Process
business unit, including the sale of the Belgian subsidiary and VirtualPlant
businesses, the outsourcing of the Process manufacturing/assembly operation in
November 2000, and personnel reductions.
For the six months ended June 30, 2001 and 2000, gross profit decreased
from $9.0 million (31.6%) in 2000 to $6.3 million (25.7%) in 2001. The gross
profit and gross profit margins for 2000 reflect the software licenses sold to
Avantium in the first quarter 2000. Excluding the gross profit from sale of
software licenses to Avantium the gross profit margin for 2000 was 23.9%.
Selling, General and Administrative Expenses. Selling, general and
administrative ("SG&A") expenses totaled $2.5 million in the quarter ended June
30, 2001, a 37.5% decrease from the $4.0 million for the same period in 2000.
SG&A expenses for the six months ended June 30, 2001 decreased 36.9% to $5.3
million as compared to the same period in the prior year. The decreases in SG&A
reflect reduced sales, marketing and corporate administration headcount, and
lower net research and product development expenditures ("R&D"), as discussed
below.
Gross R&D totaled $341,000 in the second quarter of 2001, as compared
with $1.1 million in the same period of 2000. Capitalized software development
costs totaled $150,000 and $570,000 for the second quarter of 2001 and 2000,
respectively. Accordingly, net R&D expensed and included in SG&A was $191,000
and $530,000 for the second quarter of 2001 and 2000, respectively. The
Company's R&D expenditures were reduced significantly in 2001 due to the
completion of three major development projects: VPbatch(TM), the Windows NT
version of its FlexBatch(R) Recipe and Process Management software; initiatives
to improve product ease of use of SimSuite Pro(TM), its process simulation
product; and the release of version 10.2 of the D/3 Distributed Control System
in December 2000.
Similar reductions in R&D spending have occurred in the six months
ending June 30, 2001 versus June 30, 2000. Gross R&D spending in 2001 totaled
$709,000 versus $2.2 million in 2000; capitalized software development costs
totaled $302,000 in 2001 versus $1.0 million in 2000; and net R&D expensed and
included in SG&A was $407,000 in 2001 versus $1.2 million in 2000. R&D
expenditures in 2001 are mainly related to improvements in the process control
module for the Process D/3 system.
Depreciation and Amortization. Depreciation expense totaled $173,000
and $302,000 during the quarters ended June 30, 2001 and 2000, respectively. For
the six months ended June 30, 2001 and 2000, depreciation expense was $365,000
and $613,000, respectively. The decrease in depreciation in 2001 is primarily
due to disposals of fixed assets as the Company restructured its operations and
divested certain businesses.
Amortization of goodwill was $167,000 and $129,000 during the three
months ended June 30, 2001 and 2000, respectively. During the six months ended
June 30, 2001 and June 30, 2000, amortization expense was $336,000 and $256,000,
respectively. The increase in amortization in 2001 reflects the increase in
goodwill due to payments made for contingent consideration for prior year
acquisitions.
Operating Income (Loss). The Company had operating income of $464,000
(3.9% of revenues) in the second quarter 2001, compared with an operating loss
of $1.4 million (10.6% of revenue) for the same period in 2000. For the six
months ended June 30, 2001 and June 30, 2000, operating income (loss) was
$255,000 or 1.0% of revenue and $(277,000) or (1.0)% of revenue, respectively
Excluding the operating results of the divested businesses, the
Company's operating income for the second quarter 2001 was $464,000 compared
with $313,000 for the second quarter 2000 and for the six months ended June 30,
2001 was $1.0 million compared with $710,000 for the six months ended June 30,
2000 after excluding the results of the divested businesses. The Company
attributes its business restructuring initiatives for the improvement in
operating income of its remaining businesses.
Interest Expense, Net. Net interest expense increased to $220,000 for
the quarter ended June 30, 2001, from $129,000 for the same period in 2000. This
increase is primarily attributable to an increase in the Company's average debt
outstanding during the 2001 period in order to fund working capital
requirements. For the six months ended June 30, 2001 and June 30, 2000, net
interest expense totaled $452,000 and $320,000, respectively.
Other Income (Expense), Net. Other income (expense) mainly reflects the
receipt of $147,000 equity distribution from the Company's liquidated Joint
Venture in China (this investment was written off in a prior year) offset by net
foreign currency transaction losses.
Provision for Income Taxes. The Company's effective tax rate is based
on the best current estimate of its expected annual effective tax rate. The
difference between the statutory U.S. tax rate and the Company's effective tax
rate for the quarters ended June 30, 2001 and 2000 is primarily due to the
effects of foreign operations being taxed at different rates, state income taxes
and in 2001 the impact of deferred tax assets expected to be realized in the
current year which previously had not been recognized by the Company as a result
of a valuation allowance. As of June 30, 2001 and December 31, 2000, the
aggregate deferred tax assets are recorded net of valuation allowances of
approximately $5.0 million and $5.4 million, respectively. For the six months
ended June 30, 2001, the Company reduced its valuation allowance by
approximately $400,000. The Company continues to evaluate the likelihood of
realizing its remaining deferred tax assets.
Liquidity and Capital Resources
Net cash provided by (used in) operating activities was $269,000 and
$(854,000) for the six months ended June 30, 2001 and 2000, respectively. The
gain on the Company's sale of its VirtualPlant technology and assets to Avantium
International B.V. in March 2001 ($3.3 million) was a non-monetary exchange that
had no impact on the Company's operating cash flow in 2001. Likewise, the
Company's $2.9 million licensing of software to Avantium in the first quarter
2000 for an equity stake in Avantium was also a non-monetary transaction.
Significant changes in the Company's assets and liabilities in 2001 included a
reduction in contract receivables of $639,000, a reduction in unbilled
receivables of $871,000 and a $2.1 million reduction in accounts payable and
accrued expenses.
Net cash used in investing activities for the first six months of 2001
was $489,000 , including $302,000 of capitalized software development costs and
$187,000 for capital expenditures
During the six months ended June 30, 2001, the Company utilized
$622,000 in financing activities. The Company decreased its borrowings under its
bank line of credit by $4.0 million to a total of $5.3 million, but increased
its borrowings from ManTech International Corporation ("ManTech") by $3.4
million to a total of $4.9 million.
The Company has a $10.0 million bank line of credit (the "Credit
Facility") under which the Company and its subsidiaries, GSE Process Solutions,
Inc. and GSE Power Systems, Inc., are jointly and severally liable as
co-borrowers. The Credit Facility provides for borrowings to support working
capital needs and foreign letters of credit ($2.0 million sublimit). The line is
collateralized by substantially all of the Company's assets and provides for
borrowings up to 85% of eligible accounts receivable, 50% of eligible unbilled
receivables and 40% of eligible inventory (up to a maximum of $1.2 million). GP
Strategies Corporation, a major stockholder, has provided a limited guarantee
totaling $1.8 million. The interest rate on this line of credit is based on the
bank's prime rate plus 0.75% (7.5% as of June 30, 2001), with interest only
payments due monthly. At June 30, 2001, the Company's available borrowing base
was approximately $6.4 million, of which approximately $5.3 million had been
utilized.
The Credit Facility requires the Company to comply with certain
financial ratios and precludes the Company from paying dividends and making
acquisitions beyond certain limits without the bank's consent. At June 30, 2001,
the Company was in compliance with the bank covenants.
In the fourth quarter of 2000, the Company had issued a demand
promissory note to ManTech that allowed the Company to borrow up to $1.8 million
at an interest rate of prime plus one percent. The promissory note was secured
by the Company's pledge of its equity interest in Avantium, but such security
interest was subordinate to the first lien thereon by the Company's bank. In the
first quarter of 2001, the Company borrowed an additional $550,000 from ManTech
and the promissory note was amended to increase the principal amount to $2.1
million. Subsequently, in the first quarter of 2001, and with ManTech's
approval, the Company issued a replacement promissory note in the amount of $2.1
million to ManTech pursuant to which the Company's obligations to ManTech became
unsecured and the principal is payable over a two year period, in equal
installments, commencing April 1, 2004, with interest payments to commence
monthly on July 1, 2001. The note permits ManTech to convert the principal into
GSE convertible preferred stock at a conversion rate of $100 per share. ManTech
agreed to subordinate the note to the Company's credit facility.
In 2000, ManTech provided $1.8 million in standby letters of credit to
the bank as additional collateral for the Company's Credit Facility. On April 6,
2001, ManTech agreed to allow the Company's bank to draw upon ManTech's $1.8
million letter of credit which supported the Company's credit facility, thus
paying down a portion of the Company's bank debt in exchange for additional
subordinated debt in the Company. Accordingly, the Company's promissory note to
ManTech was amended to increase the amount to $3.9 million. As permitted by the
note, ManTech has elected to convert its debt into equity in the form of
convertible preferred stock at the conversion rate of $100 per share. Thus, the
Company will issue 39,000 shares of preferred stock to ManTech in the third
quarter 2001. The convertible preferred stock will bear dividends at the rate of
6% per annum payable quarterly. Dividends will accumulate if not paid quarterly
and compounded dividends will accrue on any unpaid dividends. ManTech at its
discretion shall have the right to convert each share of convertible preferred
stock into GSE common stock at a purchase price of $2.645 per share at any time
after a one-year holding period from the date of issuance. At the end of the
third year from the date of issuance, the convertible preferred stock
automatically converts into GSE common stock. Prior to ManTech's conversion of
the convertible preferred stock to common stock, GP Strategies has the option to
acquire 50% of the convertible preferred stock for $1,950,000.
At a special shareholder's meeting on August 2, 2001, the Company's
shareholders approved an amendment to the Certificate of Incorporation
increasing GSE's authorized common stock by 10 million shares to a total of 18
million shares. With this new allocation of common stock, the Company intends to
issue approximately 3.7 million shares of common as follows: (a) 1,474,480
shares to cover the exchange of $3.9 million of the ManTech subordinated debt
into convertible preferred stock as discussed above, and (b) 2,219,701 shares
for a contemplated rights offering to non-affiliate stockholders.
In connection with the contemplated rights offering, the Company has
initiated the process to prepare a registration statement (including a
prospectus). On May 30, 2001, the Company's board of directors approved the
pricing for the rights offering at 10% above the market price on June 15, 2001.
The market price on June 15, 2001 was $2.30 per share. A 10% premium equals a
rights offering price of $2.53 per share, 5% below the price per share of common
stock issuable upon conversion of the preferred stock to be issued to ManTech.
If all shares expected to be offered are sold, the estimated proceeds to GSE
would be approximately $5.6 million before the fees and expenses related to the
offering. The principal purposes of the offering are for repayment of a $1
million loan from ManTech (see below), working capital, strategic acquisitions,
capital expenditures and general corporate purposes.
On June 25, 2001, the Company issued an additional unsecured promissory
note to ManTech that allowed the Company to borrow up to $1.0 million at an
interest rate of prime plus one percent. The note is subordinated to the
Company's credit facility. The note and accrued interest may be repaid from the
cash receipts of the contemplated rights offering. If the rights offer is not
completed, or does not provide sufficient cash to pay off the entire promissory
note and accrued interest, the principal is payable over a two year period, in
equal installments, commencing April 1, 2004, with interest payments to commence
monthly on January 1, 2002.
The Company has undertaken a number of initiatives during 2000 and 2001
to improve operating results and cash flows. Management believes the initiatives
undertaken will enable the Company to maintain compliance with the bank
financial covenants as well as provide sufficient cash flow to meet the
Company's obligations as they become due.
Item 3. Quantitative and Qualitative Disclosure about Market Risk
The Company's market risk is principally confined to changes in foreign
currency exchange rates and potentially adverse effects of differing tax
structures. The Company's exposure to foreign exchange rate fluctuations arises
in part from inter-company accounts in which costs incurred in one entity are
charged to other entities in different foreign jurisdictions. The Company is
also exposed to foreign exchange rate fluctuations as the financial results of
all foreign subsidiaries are translated into U.S. dollars in consolidation. As
exchange rates vary, those results when translated may vary from expectations
and adversely impact overall expected profitability.
The Company is also subject to market risk related to the interest
rates on its existing line of credit. As of June 30, 2001, such interest rates
are based on the bank's prime rate plus 75 basis-points.
As of June 30, 2001, $10.2 million of the Company's debt was subject to
variable interest rates. A 100 basis-point change in such rates during the
quarter ended June 30, 2001 would have changed the Company's interest expense by
approximately $54,000.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
In accordance with its conduct in the ordinary course of business,
certain actions and proceedings are pending to which the Company is a party. In
the opinion of management, the aggregate liabilities, if any, arising from such
actions are not expected to have a material adverse effect on the financial
condition of the Company.
Item 2. Changes in Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
Votes
Proposal For Against Abstain Withheld
______________________________ ___________ _______ _______ __________
1) Election of directors:
Chin-Our Jerry Jen 4,215,942 - - 333,600
Jerome I. Feldman 4,219,342 - - 330,200
George J. Pedersen 4,216,842 - - 332,700
2) Ratification of KPMG LLP as
the Company's independent
auditors for the current fiscal year 4,492,842 56,600 100 -
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
None
(b) Reports on Form 8-K
The Company filed a report on Form 8-K effective March 21, 2001
regarding the sale of certain assets relating to GSE's
VirtualPlant business under an asset purchase agreement in
exchange for an equity interest in Avantium International B.V.
("Avantium"). This report on Form 8-K included the text of a
press release dated March 12, 2001, the UK Asset Sale and
Purchase Agreement, and the Avantium Asset Sale and Purchase
Agreement filed as exhibits.
GSE SYSTEMS, INC. AND SUBSIDIARIES
FORM 10-Q
For the Quarters ended March 31, 2001 and 2000
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: August 14, 2001 GSE SYSTEMS, INC.
/S/ CHIN-OUR JERRY JEN
Chin-Our Jerry Jen
Chief Operating Officer and President
(Principal Executive Officer)
/S/ JEFFERY G. HOUGH
Jeffery G. Hough
Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)