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 March 31, 2002.
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 May 3, 2002, there were 5,869,138 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 March 31, 2002 and December 31, 2001 3
Consolidated Statements of Operations for the Three Months Ended March 31, 2002 and 4
March 31, 2001
Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 5
2002 and March 31, 2001
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2002 and 6
March 31, 2001
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition 13
Item 3. Quantitative and Qualitative Disclosure About Market Risk 19
PART II. OTHER INFORMATION 20
Item 1. Legal Proceedings 20
Item 2. Changes in Securities and Use of Proceeds 20
Item 3. Defaults Upon Senior Securities 20
Item 4. Submission of Matters to a Vote of Security Holders 20
Item 5. Other Information 20
Item 6. Exhibits and Reports on Form 8-K 20
SIGNATURES 21
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
Unaudited
March 31, 2002 December 31, 2001
--------------------- ---------------------
ASSETS
Current assets:
Cash and cash equivalents $ 1,270 $ 2,040
Restricted cash 314 164
Contract receivables 12,178 11,608
Proceeds of rights offering held by escrow agent - 1,322
Inventories 1,696 1,566
Prepaid expenses and other current assets 2,316 2,335
Deferred income taxes 587 587
--------------------- ---------------------
Total current assets 18,361 19,622
Investment in Avantium International B.V. 2,898 2,898
Property and equipment, net 1,965 1,762
Software development costs, net 3,880 3,806
Goodwill, net 2,386 2,386
Deferred income taxes 1,013 1,013
Restricted cash 340 340
Other assets 1,619 1,847
--------------------- ---------------------
Total assets $ 32,462 $ 33,674
===================== =====================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt $ 6,878 $ 2,284
Accounts payable 2,332 2,163
Accrued expenses 1,084 1,217
Accrued compensation and payroll taxes 1,207 1,676
Billings in excess of revenue earned 3,697 4,659
Accrued contract and warranty reserves 483 415
Income taxes payable 300 103
Other current liabilities 98 87
--------------------- ---------------------
Total current liabilities 16,079 12,604
Long-term debt 1,417 6,690
Accrued warranty reserves 504 528
--------------------- ---------------------
Total liabilities 18,000 19,822
--------------------- ---------------------
Commitments and contingencies
Stockholders' equity:
Common stock $.01 par value, 18,000,000 shares authorized, shares issued
and outstanding 5,869,138 and 5,741,138 in 2002 and 2001, respectively 59 57
Series A Convertible preferred stock $.01 par value, 2,000,000 shares authorized,
shares issued and outstanding 39,000 in 2002 and in 2001 - -
Additional paid-in capital 27,796 27,535
Retained earnings (deficit) - at formation (5,112) (5,112)
Retained earnings (deficit) - since formation (6,939) (7,313)
Accumulated other comprehensive loss (1,342) (1,315)
--------------------- ---------------------
Total stockholders' equity 14,462 13,852
--------------------- ---------------------
Total liabilities and stockholders' equity $ 32,462 $ 33,674
===================== =====================
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
ended March 31,
-----------------------------
2002 2001
------------- -------------
Contract revenue $ 11,274 $ 12,478
Cost of revenue 7,791 9,506
------------- -------------
Gross profit 3,483 2,972
------------- -------------
Operating expenses
Selling, general and administrative 2,618 2,820
Depreciation and amortization 140 361
------------- -------------
Total operating expenses 2,758 3,181
------------- -------------
Operating income (loss) 725 (209)
Gain on sale of assets - 3,273
Interest expense, net (72) (232)
Other income (expense), net 47 24
------------- -------------
Income before income taxes 700 2,856
Provision for income taxes 268 1,142
------------- -------------
Net income $ 432 $ 1,714
============= =============
Basic earnings per common share $ 0.06 $ 0.33
============= =============
Diluted earnings per common share $ 0.06 $ 0.33
============= =============
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
ended March 31,
----------------------------
2002 2001
------------- -------------
Net income $ 432 $ 1,714
Foreign currency translation adjustment (27) (142)
------------- -------------
Comprehensive income $ 405 $ 1,572
============= =============
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)
Three months
ended March 31,
-----------------------------
2002 2001
------------- -------------
Cash flows from operating activities:
Net income $ 432 $ 1,714
Adjustments to reconcile net income to net cash (used in)
provided by operating activities:
Depreciation and amortization 589 887
Gain on sale of assets - (3,273)
Changes in assets and liabilities:
Contract receivables (570) 1,350
Inventories, prepaid expenses and other assets (124) (62)
Accounts payable, accrued compensation and accrued expenses (475) (1,680)
Billings in excess of revenues earned (962) 501
Accrued contract and warranty reserves 44 7
Other liabilities 165 989
------------- -------------
Net cash (used in) provided by operating activities (901) 433
------------- -------------
Cash flows from investing activities:
Capital expenditures (343) (41)
Capitalized software development costs (523) (152)
------------- -------------
Net cash used in investing activities (866) (193)
------------- -------------
Cash flows from financing activities:
Proceeds from issuance of note payable to related party - 550
Repayment of note payable to related party (250) -
Restrictions of cash as collateral under line of credit (150) -
Decrease in borrowings under lines of credit (68) (1,411)
Proceeds from issuance of common stock, net of costs 1,584 -
Other financing activities, net (119) (220)
------------- -------------
Net cash provided by (used in) financing activities 997 (1,081)
------------- -------------
Effect of exchange rate changes on cash - (12)
------------- -------------
Net decrease in cash and cash equivalents (770) (853)
Cash and cash equivalents at beginning of year 2,040 1,465
------------- -------------
Cash and cash equivalents at end of period $ 1,270 $ 612
============= =============
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Three Months ended March 31, 2002 and 2001
(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 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 period ended December 31, 2001 filed with the
Securities and Exchange Commission on March 29, 2002.
2. Basic and Diluted Earnings Per Common Share
Basic earnings per share is based on the weighted average number of
outstanding common shares for the period. Diluted earnings 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 per share were as follows:
Three months
ended March 31
------------------------
2002 2001
------------- -----------
Weighted average shares outstanding - Basic 5,844,788 5,193,527
============== ==========
Weight average shares outstanding- Diluted 7,551,581 5,201,387
============= ===========
]
The difference between the basic and diluted number of weighted
average shares outstanding for the quarters ended March 31, 2002 and
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. The net income for the quarter
ended March 31, 2002 was decreased by preferred stock dividends of
$58,000 in calculating the per share amounts. For the quarter ended
March 31, 2001, there were no preferred stock dividends.
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) March 31, December 31,
2002 2001
------------- ---------------
Raw materials $ 1,268 $ 1,143
Service parts 428 423
------------- ---------------
Total inventories $ 1,696 $ 1,566
============= ===============
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 $523,000 and $152,000
for the quarters ended March 31, 2002 and 2001, respectively. Total
amortization expense was $449,000 and $526,000 for the quarters ended
March 31, 2002 and 2001, 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 and 352,102
shares of Avantium common stock, valued at $2.8 million. 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.
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, Akzo Nobel, three major European
universities and various venture capital firms.
The Company accounted for its investment in Avantium using the cost
method of accounting based on management's conclusion that the Company
did not have significant influence with respect to the operations of
Avantium.
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 U.S. and the UK. GSE received
200,000 shares of Avantium preferred stock and 280,000 shares of
Avantium common stock, which increased its equity interest in Avantium
to approximately 19% and the carrying value of its investment to $7.5
million. 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.
On February 7, 2002, Avantium completed a private placement round
of financing which resulted in 20 million Euros in new capital and the
conversion of 11 million Euros of convertible debt. The equity issuance
and debt conversion diluted GSE's ownership in Avantium to 6.1%. The
estimated fair market value of Avantium following the financing was
$47.4 million. Accordingly, the Company concluded that this transaction
was evidence of "an other than temporary decline" in the fair value of
its investment in Avantium. Thus, in the fourth quarter 2001, the
Company wrote down its investment in Avantium to $2.9 million and
recognized a $4.6 million pre-tax charge.
6. Long-term Debt
The Company's long-term debt consists of the following notes payable
and other financing arrangements:
(in thousands) March 31, December 31,
2002 2001
----------------- -----------------
Line of credit with bank $ 4,920 $ 4,988
Obligations under financing leases 2,403 2,645
Notes payable to related parties 843 1,100
Notes payable, other 129 241
----------------- -----------------
Total notes payable and financing arrangements 8,295 8,974
Less amounts payable within one year 6,878 2,284
----------------- -----------------
Long-term portion $ 1,417 $ 6,690
================= =================
Line of Credit
The Company has a $10.0 million bank line of credit 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 sub limit). 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% (5.50% as of March 31, 2002), with interest
only payments due monthly. At March 31, 2002, the Company's available
borrowing base was approximately $5.4 million, of which approximately
$4.9 million had been utilized. The credit facility expires on March 23,
2003. Accordingly, the Company has classified the borrowings under the
line of credit as current as of March 31, 2002.
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
March 31, 2002, the Company was in compliance with the covenants.
Notes Payable to Related Parties
On June 25, 2001, the Company issued an additional unsecured
promissory note to ManTech for $1.0 million at an interest rate of prime
plus one percent. The Company used the loan proceeds for working capital
purposes. The note is subordinated to the Company's credit facility. As
of March 31, 2002, the Company has $750,000 due to ManTech. The
Company has an additional unsecured promissory note to a former employee
for $93,000 which expires April 14, 2005.
Obligations under financing leases
As of March 31, 2002, the Company has five separate contracts with
a customer for the lease of certain hardware and software under 36-month
leases. The Company has accounted for the leases as sales-type leases.
The Company assigned the payments due under the sales-type leases to a
third-party financing company and received proceeds of $2,198,000 for
the year ended December 31, 2001. Since the Company remains contingently
liable for amounts due to the third-party financing company, the
remaining investment in and obligation under the financing leases are
reflected in the Company's balance sheets as follows:
(in thousands) March 31, December 31,
2002 2001
----------------- -----------------
Net investment in sales-type leases:
Prepaid expense and other assets $ 1,051 $ 1,016
Other assets 1,352 1,629
----------------- -----------------
Total net investment $ 2,403 $ 2,645
================= =================
Obligation under financing leases:
Current portion of long-term debt $ 1,051 $ 1,016
Long-term debt 1,352 1,629
----------------- -----------------
Total obligations $ 2,403 $ 2,645
================= =================
7. Series A Preferred Stock
The Series A convertible preferred stock has no voting rights and
bears dividends at the rate of 6% per annum payable quarterly. Dividends
will accumulate if not paid quarterly and compounded interest will
accrue on any unpaid dividends. ManTech at its discretion has the right
to convert each share of Series A 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. In December 2004, the
Series A convertible preferred stock automatically converts into GSE
common stock.
8. Letters of Credit
As of March 31, 2002, the Company was contingently liable for
approximately $654,000 under five 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.
9. 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 March 31, 2002 and 2001 is primarily due to the
effects of foreign operations being taxed at different rates and state
income taxes. As of March 31, 2002 and December 31, 2001, the aggregate
deferred tax assets are recorded net of a valuation allowance of $4.9
million.
10. 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 March 31, 2002
---------------------------------------------
Process Power Consolidated
Contract revenue $ 6,701 $ 4,573 $ 11,274
============ ============ ===============
Business unit contribution $ 1,652 $ (120) $ 1,532
============ ============ ===============
Three months ended March 31, 2001
---------------------------------------------
Process Power Consolidated
Contract revenue $ 5,314 $ 7,164 $ 12,478
============ ============ ===============
Business unit contribution $ (157) $ 1,024 $ 867
============ ============ ===============
The Company sold its VirtualPlant technology and assets in March
2001 (see Note 5, Investment in Avantium International B.V.). Contract
revenue for the Process segment includes revenue for the VirtualPlant
business of $507,000 for the quarter ended March 31, 2001. Business unit
contribution for the Process segment includes a loss for VirtualPlant of
$471,000 for the quarter ended March 31, 2001.
A reconciliation of segment business unit contribution to
consolidated income before taxes is as follows:
(in thousands) Three months
ended March 31,
----------------------------
2002 2001
------------- -------------
Segment business unit contribution $ 1,532 $ 867
Corporate expenses (760) (1,052)
Gain on disposition of assets - 3,273
Interest expense, net (72) (232)
------------- -------------
Income before income taxes $ 700 $ 2,856
============= =============
11. Recent Accounting Pronouncements
On January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 142 "Goodwill and Other Intangible Assets"
("SFAS No. 142"). SFAS No. 142 requires that goodwill and intangible
assets with indefinite useful lives no longer be amortized, but instead
tested for impairment at least annually. The Company is required to
complete the first step of the transitional impairment test for goodwill
within six months of adoption of SFAS No. 142 and to complete the final
step of the transitional impairment test by the end of the calendar year.
The Company anticipates the results of this assessment will not have a
material impact on the consolidated financial statements.
Pro forma net income and net income per share for the three months
ended March 31, 2001, adjusted to eliminate historical amortization of
goodwill and related tax effects, are as follows:
(in thousands, except for per share amounts)
Three months
ended March 31, 2001
Net income, as reported $ 1,714
Add: goodwill amortization, net of tax 149
------------------
Net income, as adjusted $ 1,863
==================
Net income per share, as reported:
Basic $ 0.33
Diluted $ 0.33
Net income per share, as adjusted:
Basic $ 0.36
Diluted $ 0.36
In August 2001, the FASB issued Statement of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets." This Statement supersedes SFAS No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be
Disposed Of" and APB Opinion No. 30, "Reporting the Results of
Operations--Reporting the Effects of Disposal of a Segment of Business,
and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions. " Adoption of this Statement, on January 1, 2002, did not
have a material impact on the Company's financial statements.
12. Reclassifications
Certain prior year amounts have been reclassified to conform to the
current year presentation.
GSE SYSTEMS, INC. AND SUBSIDIARIES
FORM 10-Q
For the Three Months ended March 31, 2002 and 2001
Item 2. Management's Discussion and Analysis of Results of Operations and
Financial Condition Cautionary Statement Regarding Forward-Looking Statements
This report contains certain forward-looking statements. Any statements
contained here in that are not statements of historical facts may be deemed
forward-looking statements. These statements are based on management's current
beliefs and expectations and are subject to numerous risks and uncertainties and
changes in circumstances. Actual results may differ materially from these
forward-looking statements due to changes in global, economic, business,
governmental, technical, competitive, market and regulatory factors.
Critical Accounting Policies and Estimates
In preparing the Company's financial statements, management makes
several estimates and assumptions that affect the Company's reported amounts of
assets, liabilities, revenues and expenses. Those accounting estimates that have
the most significant impact on the Company's operating results and place the
most significant demands on management's judgment are discussed below. For all
of these policies, management cautions that future events rarely develop exactly
as forecast, and the best estimates may require adjustment.
Revenue Recognition on Long-Term Contracts. The Company uses the
percentage-of completion revenue recognition methodology to record revenue under
its long-term fixed-price contracts in accordance with the AICPA Statement of
Position 81-1, "Accounting for Performance of Construction-Type and Certain
Production-Type Contracts". This methodology recognizes income as work
progresses on the contract and is based on an estimate of the income earned to
date, less income recognized in earlier periods. The Company bases its estimate
of the degree of completion of the contract by reviewing the relationship of
costs incurred to date to the expected total costs that will be incurred on the
project. The Company's project managers are responsible for estimating the costs
to be incurred at the beginning of each project and are responsible for updating
the estimate as the project progresses. Management reviews the status of each
project periodically with the project managers and determines whether the cost
estimates are reasonable. If changes in the estimated costs to complete the
projects are required, the cumulative impact on the percentage of completion
revenue calculation is recognized in the period identified. Whenever evidence
indicates that the estimated total cost of a contract will exceed its total
contract value, the Company's operating results are charged for the full amount
of the estimated losses immediately. Uncertainties inherent in the performance
of contracts include labor availability and productivity, material costs, change
order scope and pricing, software modification issues and customer acceptance
issues. The reliability of these cost estimates is critical to the Company's
revenue recognition as a significant change in the estimates can cause the
Company's revenue and related margins to change significantly from the amounts
estimated in the early stages of the project.
Capitalization of Computer Software Development costs. In accordance
with SFAS 86 "Accounting for the Costs of Computer Software to Be Sold, Leased,
or Otherwise Marketed", the Company capitalizes computer software development
costs incurred after technological feasibility has been established, but prior
to the release of the software product for sale to customers. Once the product
is available to be sold, the Company begins to amortize the costs over the
estimated useful life of the product, which normally ranges from three to five
years. At March 31, 2002, the Company has net capitalized software development
costs of $3.9 million. On an annual basis, the Company assesses the recovery of
the unamortized software computer costs by estimating the net undiscounted cash
flows expected to be generated by the sale of the product. If the undiscounted
cash flows are not sufficient to recover the unamortized software costs the
Company will write-down the investment to its estimated fair value based on
future discounted cash flows. The excess of any unamortized computer software
costs over the related net realizable value is written down and charged to
income. Significant changes in the sales projections could result in an
impairment with respect to the capitalized software that is reported on the
Company's balance sheet.
Deferred Income Tax Valuation Allowance. Deferred income taxes arise
from temporary differences between the tax bases of assets and liabilities and
their reported amounts in the financial statements. As required by SFAS 109
"Accounting for Income Taxes", management makes an annual assessment of the
realizability of the Company's deferred tax assets. In making this assessment,
management considers whether it is more likely than not that some or all of the
deferred tax assets will not be realized. The ultimate realization of deferred
tax assets is dependent upon the generation of future taxable income during the
periods in which those temporary differences become deductible. Management
considers the scheduled reversal of deferred tax liabilities and projected
future taxable income of the Company in making this assessment. A valuation
allowance is recorded to reduce the total deferred income tax assets to its
realizable value. At March 31, 2002, the Company's deferred tax assets related
primarily to a U.S. net operating loss carryforward of $13.5 million which can
be utilized over the next twenty years. Management believes it is more likely
than not that the Company will generate sufficient taxable income to recover
$1.6 million of its deferred tax asset. The recovery of the remaining net
deferred tax asset is significantly less certain and, accordingly, the Company
has established a valuation allowance for the balance of its deferred tax assets
of $4.9 million. If future taxable income is less than management's estimates,
the amount of the net deferred tax assets on the Company's balance sheet will
require an additional valuation allowance. Additionally, if the Company is able
to realize higher taxable income the valuation allowance could be reduced.
General Business Environment
GSE Systems, Inc. ("GSE Systems", "GSE" or the "Company") is a world
leader in real-time power plant simulation and process automation and control.
The Company provides simulation solutions and services to the nuclear and fossil
electric utility industry, as well as process industries such as the chemical
and petrochemical industries. The Company's process automation products optimize
batch and hybrid plant control for the specialty chemical, food and beverage,
and pharmaceutical industries. The Company operates through two business
segments, Power Simulation and Process Automation.
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. The Company is web-enabling its simulation
products to provide cost effective solutions for fossil simulation. In addition,
the deregulation of the electric power industry has increased 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.
The Company recently announced an agreement with RedStorm Scientific
LLC for the use of GSE software in the drug discovery process. RedStorm
Scientific LLC is a privately held computational drug design company. Its
technology (patents pending), known as Fyrestar, utilizes bio-informatics and
computer-aided molecular design to create lead compounds that are developed into
successful new drugs. It greatly reduces the significant cost associated with
screening thousands of potential compounds common in the drug development
process. Under the terms of the agreement, GSE will utilize its eSMART
simulation software and graphical user interface that will allow scientists to
easily access and use the Fyrestar technology graphically displaying results as
the calculations take place. This will allow scientists the opportunity to
adjust their assumptions in real time, and further improve results.
Process Control Business
To expand within its traditional customer base and gain new customers,
Process has embarked upon a program to develop a lower-cost, next generation
process controller using the latest microprocessor technology. This new
controller will be part of the second quarter 2002 D/3 product release which
will also include enhanced alarming and improved security features. This new
version of the D/3 product, called D/3 Compact, will allow the Company 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. This more cost effective solution will enable
existing customers to apply automation to areas of their plants that could not
previously afford the benefits of a full distributed control system. The Company
has initiated a campaign to find expanded distribution channels for its new
products, particularly in smaller, batch applications where previously the power
of the D/3 could not be cost effectively applied.
Plant Security Business
In light of recent security concerns at nuclear plants and other
sensitive locations, the Company has begun marketing the technology it acquired
several years ago for plant access control and intrusion detection. The Company
has implemented its system at several nuclear power plants in the U.S. and is
pursuing applications at other facilities. The system is a command and control
center that integrates information card readers, retinal scanners, closed
circuit TV and other filed devices used for intrusion detection and personnel
access control. The Company has recently hired a manager to develop a business
plan for the expansion of this security business. The Company is also teaming
with ManTech Security Technologies Company, a subsidiary of one of its major
shareholders, to provide turnkey capabilities to the nuclear industry. Services
include threat and vulnerability assessments, risk mitigation plans,
cost/benefit analysis, security system design, implementation, testing and
training.
The Company also believes it is uniquely qualified to apply its plant
design and operations knowledge as wells as simulation technology to help
customers analyze security threats and develop strategies to test plant recovery
strategies in the event of an accident.
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 March 31,
----------------------------------------------
2002 % 2001 %
---------- --------- ----------- ---------
Contract revenue $11,274 100.0 % $12,478 100.0 %
Cost of revenue 7,791 69.1 % 9,506 76.2 %
---------- --------- ----------- ---------
Gross profit 3,483 30.9 % 2,972 23.8 %
---------- --------- ----------- ---------
Operating expenses:
Selling, general and administrative 2,618 23.2 % 2,820 22.6 %
Depreciation and amortization 140 1.3 % 361 2.9 %
---------- --------- ----------- ---------
Total operating expenses 2,758 24.5 % 3,181 25.5 %
---------- --------- ----------- ---------
Operating income (loss) 725 6.4 % (209) (1.7)%
Gain on sale of assets - 0.0 % 3,273 26.2 %
Interest expense, net (72) (0.6)% (232) (1.9)%
Other income (expense), net 47 0.4 % 24 0.2 %
---------- --------- ----------- ---------
Income before income taxes 700 6.2 % 2,856 22.9 %
Provision for income taxes 268 2.4 % 1,142 9.2 %
---------- --------- ----------- ---------
Net income $ 432 3.8 % $ 1,714 13.7 %
========== ========= =========== =========
Contract Revenue. Total contract revenue for the quarter ended March
31, 2002 totaled $11.3 million, which was 9.6% lower than the $12.5 million
total revenue for the quarter ended March 31, 2001.
The Process business unit's revenue was $6.7 million for the first
quarter 2002 compared with $5.3 million in the same period of 2001, a 26.4%
increase. The increase in Process' revenue is mainly attributable to several
significant orders received from Westinghouse Savannah River Corporation. In the
first quarter 2002, revenue generated from work performed for Westinghouse
Savannah River Corporation totaled 49.3% of total Process revenue, versus 35.0%
in the first quarter 2001. Included in 2001 revenue was $507,000 related to
Process's VirtualPlant business which was sold to Avantium International B.V. in
March 2001.
The Power business unit revenue decreased 36.2% in the three months
ended March 31, 2002 as compared to the same period in the prior year, from $7.2
million to $4.6 million. Although there was increased activity in the U.S.
nuclear upgrade market in the first quarter 2002 as compared to the prior year,
international revenues have decreased due to the completion of several large
projects.
Gross Profit. Gross profit totaled $3.5 million (30.9% of revenue) for
the quarter ended March 31, 2002, as compared with $3.0 million (23.8% of
revenue) for the quarter ended March 31, 2001. The improvement in gross profit
margins for the first quarter 2002 reflects the sale of Process' VirtualPlant
business in March 2001 (this business had negative gross profit of $264,000 in
the first quarter 2001), higher Process project margins, and lower software
amortization.
Selling, General and Administrative Expenses. Selling, general and
administrative ("SG&A") expenses totaled $2.6 million in the quarter ended March
31, 2002, a 7.2% decrease from the $2.8 million for the same period in 2001. The
Process business unit hired one additional salesperson in the first quarter
2002, as well as a new marketing manager who has been charged with developing
the business unit's marketing strategy, revitalizing the company's marketing
collateral, and planning the product introductions for the D/3Version 11 and the
new D/3 Compact. The Power business has hired two marketing personnel for its
security business. These increases were more than offset by a decrease in the
corporate expenses (corporate first quarter 2001 expenses included $200,000 of
severance costs), a reduction in SG&A related to Process' VirtualPlant business
which was sold in March 2001, and a reduction in the net research and product
development expenditures ("R&D"), as discussed below.
Gross R&D totaled $626,000 in the first quarter of 2002, as compared
with $368,000 in the same period of 2001. Capitalized software development costs
totaled $523,000 and $152,000 for the first quarter of 2002 and 2001,
respectively. Accordingly, net R&D expensed and included in SG&A was $102,000
and $216,000 for the first quarter of 2002 and 2001, respectively. The
increase in the Company's R&D expenditures was related to:
-- the development of the Process D/3 Compact, a smaller, redesigned
version of the D/3 distributed control system which is aimed at smaller
automation applications. This entry level offering will combine the low
cost found in PLC solutions with the high functionality of a
distributed control system. This new product is expected to be released
by the end of the 2002.
-- The replacement of the Graphic User Interfaces (GUI) for our Power
GSuite and Topmeret tools with a Java based GUI, which will provide
platform independence and internet enabling.
Depreciation and Amortization. Depreciation expense totaled $140,000
and $192,000 during the quarters ended March 31, 2002 and 2001, respectively.
The decrease in depreciation in the first quarter 2002 as compared to the same
period in 2001 is due to certain assets becoming fully depreciated.
Due to the Company's adoption of SFAS No. 142 "Goodwill and Other
Intangible Assets" on January 1, 2002, goodwill is no longer amortized, but is
subject to an annual test of impairment at least annually. Thus, the Company
recognized $169,000 of goodwill amortization in the first quarter 2001 versus
none in the first quarter 2002. See Footnote 10, "Recent Accounting
Pronouncements" in the Notes to Consolidated Financial Statements.
Gain on Sale of Assets. On March 6, 2001, the Company sold its
VirtualPlant business technology and assets to Avantium International B.V. GSE
received 8% of Avantium's stock, thus increasing its holdings in Avantium to
approximately 19%, and recognized a gain on the sale of $3.3 million, before
income taxes. This gain was determined based on the estimated fair market value
of the Avantium stock received, based on an independent appraisal, less the book
value of the assets sold, approximately $700,000 in severance costs payable to
certain former employees of VirtualPlant that were not hired by Avantium, and
other transaction expenses. See Footnote 5, "Investment in Avantium
International B.V." in the Notes To Consolidated Financial Statements.
Operating Income (Loss). The Company had operating income of $725,000
(6.4% of revenue) in the first quarter 2002, as compared with an operating loss
of $209,000 (1.7% of revenue) for the same period in 2001. The increase was due
to higher gross margins in the first quarter 2002, the reduction in SG&A
expenditures, and the change in accounting methodology for goodwill amortization
as of January 1, 2002.
Interest Expense, Net. Net interest expense decreased 69% from $232,000
in the quarter ended March 31, 2001 to $72,000 for the same quarter in 2002.
This decrease is due to lower interest rates in the first quarter 2002 versus
2001 (5.5% average and 8.92% average, respectively), a reduction in the average
bank debt outstanding ($7.3 million average for the three months ended March 31,
2001 versus $4.5 million average for the twelve months ended march 31, 2002),
and a reduction in the average balance outstanding on the Company's subordinated
debt to ManTech ($1.9 million average for the first quarter 2001 versus $750,000
average for the first quarter 2002).
Other Income (Expense), Net. Other income (expense) mainly reflects
recognized foreign currency transaction gains.
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 March 31, 2002 and 2001 is primarily due to the
effects of foreign operations being taxed at different rates and state income
taxes. As of March 31, 2002 and December 31, 2001, the aggregate deferred tax
assets are recorded net of a valuation allowance of $4.9 million.
Liquidity and Capital Resources
As of March 31, 2002, the Company's cash and cash equivalents totaled
$1,270,000, compared to $2,040,000 at March 31, 2001.
Cash from operating activities. Net cash used in operating activities
was ($901,000) for the quarter ended March 31, 2002. Significant changes in the
Company's assets and liabilities in 2002 included:
-- an increase in contract receivables of $571,000 largely related to the
Westinghouse Savannah River Corp. projects, and
-- a $962,000 reduction in billings in excess of revenues earned. The
Company had received orders from two Process customers in the third
quarter 2001 that allowed GSE to invoice the customer in full prior to
the work being completed. The reduction in billings in excess reflects
the completion of a portion of these two contracts in the first quarter
2002.
Net cash provided by operating activities for the quarter ended March
31, 2001 was $433,000. The gain on the Company's sale of its VirtualPlant
technology and assets to Avantium International B.V. ($3.3 million) was a
non-monetary asset exchange that had no impact on the Company's operating cash
flow in 2001. Significant changes in the Company's assets and liabilities in
2001 included a reduction in contract receivables of $1.4 million and a $1.7
million reduction in accounts payable and accrued expenses. The Company issued a
significant number of customer invoices in December 2000 which were collected in
the first quarter 2001, and the cash received was used to paydown the Company's
liabilities.
Cash used in investing activities. Net cash used in investing
activities was $866,000 in the first quarter 2002, including $523,000 of
capitalized software development costs and $343,000 for capital expenditures.
In the first quarter 2001, net cash used in investing activities was
$193,000, consisting of $152,000 of capitalized software development costs and
$41,000 for capital expenditures.
Cash provided by financing activities. During the quarter ended March
31, 2002, the Company generated $997,000 net cash through financing activities.
The Company received $1.3 million from its escrow agent in January 2002 from a
fixed-price rights offering which was completed on December 21, 2001 and
received $262,000 from the exercise of employee stock options. The Company
decreased its borrowings under its bank line of credit by $68,000 to a total of
$4.9 million, and decreased its borrowings from ManTech International
Corporation by $250,000 to a total of $750,000. In addition, the Company issued
a $150,000 letter of credit that was cash collateralized. Letters of credit are
issued by the Company in the ordinary course of business through banks as
required by certain contracts and proposal requirements.
In the first quarter of 2001, the Company utilized $1.1 million net
cash in financing activities. The Company decreased its borrowings under its
bank line of credit by $1.4 million to a total of $7.9 million. 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 of which $1.6 million was outstanding at December 31, 2000. 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.
Credit Facilities
The Company has a $10.0 million bank line of credit with a bank which
matures on March 23, 2003. The credit facility provides for borrowings up to a
total $10.0 million to support working capital needs and foreign letters of
credit. At March 31, 2002, the Company's available borrowing base was $5.4
million, of which approximately $4.9 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 March 31, 2002, the Company was in
compliance with the bank covenants. As of March 31,2002, the Company has
classified the borrowings under the line of credit as current. See Note 6,
"Long-term Debt", in the Notes to Consolidated Financial Statements" for
additional details about this line of credit.
On June 25, 2001, the Company issued an 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. In January 2002, the Company repaid ManTech $250,000 of the note from
the proceeds of a fixed-price rights offering that was completed in December
2001.
On December 5, 2001, ManTech elected to convert $3.9 million of
subordinated debt into Series A convertible preferred stock at a conversion rate
of $100 per share. The Series A convertible preferred stock has no voting rights
and bears dividends at the rate of 6% per annum payable quarterly. Dividends
will accumulate if not paid quarterly and compounded interest will accrue on any
unpaid dividends. ManTech at its discretion has the right to convert each share
of Series A 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
Series A convertible preferred stock automatically converts into 1,474,480
shares of GSE common stock. Prior to ManTech's conversion of the Series A
convertible stock to common stock, GP Strategies has the option to acquire 50%
of the Series A convertible preferred stock for $1,950,000.
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 March 31, 2002, such interest rates
are based on the bank's prime rate plus 75 basis-points.
As of March 31, 2002, $5.7 million of the Company's debt was subject to
variable interest rates. A 100 basis-point change in such rates during the
quarter ended March 31, 2002 would have changed the Company's interest expense
by approximately $14,000.
GSE SYSTEMS, INC. AND SUBSIDIARIES
FORM 10-Q
For the Quarters ended March 31, 2001 and 2000
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
None
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 25, 2002
regarding GSE's execution of the Subscription and Shareholders'
Agreement for Avantium International B.V. ("Avantium") on January
22, 2002. This Agreement superseded the Subscription and
Shareholders' Agreement dated February 24, 2000, as amended.
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: May 10, 2002 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)