UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
------------------------
FORM 10-Q
------------------------
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ----- EXCHANGE ACT OF 1934
For the Quarter Ended March 31, 1997
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: 0-21240
---------------------------------
HDS NETWORK SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware 23-2705700
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
400 Feheley Drive
King of Prussia, Pennsylvania 19406
(Address of principal executive offices)
(610) 277-8300
(Registrant's telephone number including area code)
---------------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--- ---
As of May 9, 1997, there were outstanding 5,757,437 shares of the Registrant's
Common Stock.
Page 1 of 15 pages
Exhibit Index is on page 14
HDS NETWORK SYSTEMS, INC.
------------------------
INDEX
-----
Page
Number
------
PART I. FINANCIAL INFORMATION
Item 1. Unaudited Consolidated Financial Statements
Consolidated Balance Sheets:
March 31, 1997 and June 30, 1996 3
Consolidated Statements of Operations:
Three and Nine Months Ended March 31, 1997 and 1996 4
Consolidated Statements of Cash Flows:
Nine Months Ended March 31, 1997 and 1996 5
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 10
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders 14
Item 6. Exhibits and Reports on Form 8-K 14
Signatures 15
HDS NETWORK SYSTEMS, INC.
------------------------
CONSOLIDATED BALANCE SHEETS
---------------------------
March 31, June 30,
(Unaudited) 1997 1996
-------------------------------------
ASSETS
------
CURRENT ASSETS:
Cash and cash equivalents $ 1,766,854 $ 2,700,298
Accounts receivable, net of allowance for doubtful accounts 6,516,532 4,914,007
Inventories 4,027,120 2,354,254
Prepaid expenses and other 1,655,728 761,156
Deferred income taxes 435,470 435,470
----------------- -----------------
Total current assets 14,401,704 11,165,185
PROPERTY AND EQUIPMENT, net 733,791 668,420
CAPITALIZED SOFTWARE, net 275,517 190,298
----------------- -----------------
$ 15,411,012 $ 12,023,903
================= =================
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
CURRENT LIABILITIES:
Current portion of long-term debt $ - $ 4,232
Accounts payable 3,637,422 1,927,897
Accrued expenses 347,781 316,937
Deferred revenue 250,599 199,944
----------------- -----------------
Total current liabilities 4,235,802 2,449,010
----------------- -----------------
LONG-TERM DEBT - 3,733
----------------- -----------------
DEFERRED INCOME TAXES 89,270 89,270
----------------- -----------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock, $.001 par value, 1,000,000 shares authorized and none issued and
outstanding --- ---
Common stock, $.001 par value, 50,000,000 shares
authorized, 5,727,233 and 5,619,595 shares issued and outstanding 5,727 5,620
Additional paid-in capital 8,995,690 8,268,123
Retained earnings 2,167,020 1,329,722
Deferred compensation ( 82,497) (121,575)
----------------- -----------------
Total stockholders' equity 11,085,940 9,481,890
----------------- -----------------
$ 15,411,012 $ 12,023,903
================= =================
The accompanying notes are an integral part of these financial statements.
HDS NETWORK SYSTEMS, INC.
------------------------
CONSOLIDATED STATEMENTS OF OPERATIONS
-------------------------------------
(UNAUDITED)
Three Months Ended Nine Months Ended
March 31, March 31,
--------------------------------------------- ---------------------------------------
1997 1996 1997 1996
----------------- ----------------- ----------------- -----------------
NET REVENUES $ 6,092,369 $ 3,681,011 $ 18,472,791 $ 15,686,094
COST OF REVENUES 3,845,093 2,647,720 12,332,528 11,855,927
----------------- ----------------- ----------------- -----------------
Gross profit 2,247,276 1,033,291 6,140,263 3,830,167
----------------- ----------------- ----------------- -----------------
OPERATING EXPENSES:
Sales and marketing 993,660 591,991 2,776,150 1,441,542
General and administrative 438,496 297,373 1,231,247 887,558
Research and development 404,712 193,207 967,824 486,843
----------------- ----------------- ----------------- -----------------
Total operating expenses 1,836,868 1,082,571 4,975,221 2,815,943
----------------- ----------------- ----------------- -----------------
Operating income (loss) 410,408 (49,280) 1,165,042 1,014,224
INTEREST INCOME, net 25,687 57,182 101,543 178,672
----------------- ----------------- ----------------- -----------------
Income before income taxes 436,095 7,902 1,266,585 1,192,896
INCOME TAXES 155,062 2,845 429,286 433,787
----------------- ----------------- ----------------- -----------------
NET INCOME $ 281,033 $ 5,057 $ 837,299 $ 759,109
================= ================= ================= =================
EARNINGS PER SHARE $ .05 $ .02 $ .14 $ .13
================= ================= ================= =================
WEIGHTED AVERAGE NUMBER OF SHARES
OUTSTANDING 10,941,471 10,553,186 10,937,774 7,257,717
================= ================= ================= =================
The accompanying notes are an integral part of these financial statements.
HDS NETWORK SYSTEMS, INC.
------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
-------------------------------------
Nine Months Ended
(Unaudited) March 31,
-----------------------------------
1997 1996
---------------- ----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 837,299 $ 759,109
Adjustments to reconcile net income to net cash
provided by (used in) operating activities-
Depreciation and amortization 169,136 279,770
Amortization of deferred compensation 39,078 26,051
Changes in operating assets and liabilities- (Increase) decrease in:
Accounts receivable (1,602,525) 3,665,510
Inventories (1,672,866) (701,775)
Prepaid expenses and other (894,572) (448,550)
Increase (decrease) in:
Accounts payable 1,709,525 (1,421,012)
Accrued expenses 30,844 (282,372)
Deferred revenue 50,655 17,702
Income taxes payable - (626,375)
---------------- ----------------
Net cash provided by (used in)
operating activities (1,333,426) 1,268,058
---------------- ----------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (234,508) (136,982)
Reduction in short-term investments - 959,324
Capitalized software (85,219) (92,512)
---------------- ----------------
Net cash provided by (used in) investing activities (319,727) 729,830
---------------- ----------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of line of credit - (589,000)
Proceeds from the exercise of stock options 727,674 -
Principal payments on long-term debt (7,965) (2,246)
---------------- ----------------
Net cash provided by (used in)
financing activities 719,709 (591,246)
---------------- ----------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (933,444) 1,406,642
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 2,700,298 2,184,983
---------------- ----------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 1,766,854 $ 3,591,625
================ ================
SUPPLEMENTAL DISCLOSURES OF NONCASH
OPERATING ACTIVITIES:
Cash paid for income taxes $ 27,213 $ 1,001,000
Cash paid for interest $ 3,556 $ 10,475
The accompanying notes are an integral part of these financial statements.
HDS NETWORK SYSTEMS, INC.
-------------------------
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
----------------------------------------------------
1. BASIS OF PRESENTATION:
----------------------
The accompanying unaudited consolidated financial statements of HDS Network
Systems, Inc. and Subsidiaries (the "Company") have been prepared in conformity
with generally accepted accounting principles. The interim financial
information, while unaudited, reflects all normal recurring adjustments which
are, in the opinion of management, necessary to present a fair statement of
financial position and operating results for the interim periods presented. The
results of the three- and nine-month period ended March 31, 1997 are not
necessarily indicative of results expected for the full year. These financial
statements should be read in conjunction with the audited financial statements
and notes thereto included in the Company's Annual Report on Form 10-K filed
with the Securities and Exchange Commission.
2. MAJOR CUSTOMERS:
----------------
Net revenues from one customer represented 35% of total net revenues for the
three months ended March 31,1997 and net revenues from two customers represented
12% and 11% of net revenues for the nine-month period then ended. Net revenues
from one customer represented 20% of total net revenues for the three months
ended March 31, 1996 and 19% of total net revenues for the nine month period
then ended, while net revenues from another customer represented 25% of total
net revenues for the nine months ended March 31, 1996. At March 31, 1997, the
Company had receivables from the above customers of approximately $2,781,000.
3. NEW ACCOUNTING PRONOUNCEMENT:
-----------------------------
Statement of Financial Accounting Standards No. 129, "Disclosure of Information
About Capital Structure", was issued in February 1997. SFAS 129 will not result
in any substantive changes in the Company's disclosure.
4. INVENTORIES:
------------
Inventories are stated at the lower of cost or market (first-in, first-out
method) and consisted of the following:
March 31, June 30,
------------------------------------
1997 1996
---------------- ----------------
Purchased components and subassemblies $ 1,455,804 $ 942,210
Work-in-process 289,148 173,792
Finished goods 2,282,168 1,238,252
---------------- ----------------
$ 4,027,120 $ 2,354,254
================ ================
5. LINE OF CREDIT:
---------------
The Company has a $5,000,000 revolving line of credit (none outstanding at March
31, 1997) with a bank which expires on December 31, 1997, subject to annual
renewal. Borrowings under the line are at the bank's prime rate. Under the line,
the Company is required to maintain specified ratios of working capital and debt
to net worth, as defined.
6. LONG-TERM DEBT:
---------------
The Company had a term loan payable in monthly installments of approximately
$400, including interest at 7.8%, with final payment due in July 1998. The loan
was paid off in November 1996.
7. STOCK OPTIONS:
--------------
The Company has a stock option plan for employees and directors which provides
for the grant of incentive and non-qualified stock options. The Company is
authorized to issue options for the purchase of up to 1,100,000 shares of common
stock. Under the terms of the plan, the exercise price of options granted cannot
be less than fair market value on the date of grant. Except for options issued
to non-employee directors, options generally vest and become exercisable ratably
over four years, and expire five years from the grant date. Options granted to
non-employee directors are made automatically upon the date they are first
elected and on an annual basis pursuant to a formula set forth in the plan.
Initial options granted to non-employee directors become fully vested nine
months after the date of grant, and annual options become fully vested one year
after the date of grant. As of March 31, 1997, the Company had options
outstanding for the purchase of 765,188 shares of common stock at prices ranging
from $5.13 to $7.625 per share. Options to purchase 382,563 shares of common
stock were vested at March 31, 1997.
8. EARNINGS PER SHARE:
-------------------
The Company utilized the modified treasury stock method for the three- and
nine-month periods ended March 31, 1997 to compute earnings per share since
common share equivalents at the end of the period exceeded 20 percent of the
number of common shares outstanding. Earnings per common and common equivalent
share (primary earnings per share) is computed using the weighted average number
of common shares and common share equivalents (stock options and warrants, using
the modified treasury stock method) outstanding. The Company's reported net
income is increased for the earnings per share calculation by the after-tax
imputed interest income that would have been earned on the net proceeds, after
the assumed repurchase of 20 percent of outstanding common shares, from the
conversion of the Company's stock options and warrants.
Earnings per share for the three- and nine-month periods ended March 31, 1997
and 1996 are calculated as follows:
Three months ended Nine months ended
March 31, March 31,
1997 1996 1997 1996
---- ---- ---- ----
Net income as reported $ 281,033 $ 5,057 $ 837,299 $ 759,109
Imputed interest income, net of income taxes 228,767 210,892 687,996 210,892
--------- --------- --------- ---------
Adjusted net income $ 509,800 $ 215,949 $1,525,295 $ 970,001
========== ========== ========== ==========
Actual number of shares outstanding 5,741,587 5,607,850 5,741,587 5,607,850
Net additional shares arising from exercise of warrants and
options 5,199,884 4,945,336 5,196,187 1,649,867
--------- --------- --------- ---------
Weighted average number of shares outstanding 10,941,471 10,553,186 10,937,774 7,257,717
========== ========== ========== =========
Earnings per share $ .05 $ .02 $ .14 $ .13
======== ======== ======== ========
Statement of Financial Accounting Standards No. 128 (SFAS 128), "Earnings per
Share", which supersedes APB Opinion No. 15, "Earnings per Share", was issued in
February 1997. SFAS 128 requires dual presentation of basic and diluted earnings
per share (EPS) for complex capital structures on the face of the income
statement. Basic EPS is computed by dividing income by the weighted average
number of common shares outstanding for the period. Diluted EPS reflects the
potential dilution from the exercise or conversion of securities into common
stock, such as stock options. SFAS is required to be adopted for the Company's
fiscal year ending June 30, 1998 and, when adopted, will require restatement of
prior periods' EPS.
Early application of SFAS 128 is prohibited, although footnote disclosure of pro
forma EPS amounts is required. The effect of adoption of SFAS is included on a
pro forma basis as presented below.
Three months ended Nine months ended
March 31, March 31,
1997 1996 1997 1996
---- ---- ---- ----
Earnings per share, as reported $ .05 $ .02 $ .14 $ .13
======== ======== ======== ========
Proforma information:
Basic earnings per share $ .05 $ -0- $ .15 $ .14
======== ======== ======== ========
Diluted earnings per share $ .04 $ -0- $ .11 $ .12
======== ======== ======== ========
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
Introduction
The Company provides network computers and related software that are
designed to integrate and deliver information to the desktop cost effectively in
network-centric environments. The Company's @workStation network computers
combine a variety of windowed-display, graphical user interface ("GUI") and
communications industry standards to provide the user seamless and transparent
access to all information, including text, graphics, audio and video data, on
any type of network. The Company has licensed Netscape Navigator/TM/ and Sun
Microsystems, Inc.'s Java/TM/ technology that it has incorporated into its
products to provide cost-effective access to information and applications within
the corporate enterprise and on the Internet.
The Company's network computer product line was introduced in June 1996.
Prior to the introduction of the network computer, the Company manufactured and
marketed a family of desktop computing devices, including multimedia-capable X
Window terminals.
The Company's current strategy is to become a leader in the emerging
market for network computers by focusing on expanding its operating system
software products and its network computer hardware. The Company also plans to
continue to seek to acquire strategic technologies, products or businesses
complementary to its current business. The Company sells its products in North
America directly to end users and through resellers, system integrators and
OEMs. International sales are generally made through distributors.
In August 1996, the Company formed a new subsidiary, Information
Technology Consulting, Inc. ("ITC") for the purpose of acquiring companies in
the network computer services field, including information technology staffing
companies and client-server consulting companies. In January 1997 the Company
announced that ITC entered into a definitive agreement to acquire the business
of Global Consulting Group ("Global"), an information technology staffing and
consulting company with revenues of approximately $11.4 million and operating
income of approximately $1.4 million for the year ended December 31, 1996. Under
the terms of the agreement, ITC will purchase Global subject to the consummation
by ITC of a public offering of its stock. In March 1997 the Company announced
that ITC entered into a definitive agreement to acquire the business of The
Reohr Group, Inc. ("Reohr"), an information technology staffing and consulting
company with revenues of approximately $16.4 million and operating income of
approximately $3.4 million for the year ended December 31, 1996. Under the terms
of the agreement, ITC will purchase Reohr subject to the consummation by ITC of
a public offering of its stock. The Company expects that ITC will seek to enter
into definitive agreements with respect to additional acquisitions during the
fourth quarter of fiscal 1997.
Results of Operations
The following table sets forth, for the periods indicated, certain items
from the Company's consolidated statements of operations as a percentage of net
revenues.
Three Months Ended Nine Months Ended
March 31, March 31,
----------- -------------
1997 1996 1997 1996
---- ---- ---- ----
Gross profit 36.9% 28.1% 33.2% 24.4%
Operating expenses:
Sales and marketing 16.3 16.1 15.0 9.2
Research and development 6.6 5.2 5.2 3.1
General and administrative 7.3 8.1 6.7 5.7
Operating income (loss) 6.7 (1.3) 6.3 6.4
Interest income, net 0.4 1.5 0.6 1.1
Income before taxes 7.1 0.2 6.9 7.5
Income taxes 2.5 0.1 2.4 2.8
--- --- --- ---
Net income 4.6% 0.1% 4.5% 4.7%
==== ==== ==== ====
For the three months ended March 31, 1997, net revenues increased by
65.5% to $6,092,369 from $3,681,011 for the comparable period in the prior
fiscal year. Net revenues for the nine months ended March 31, 1997 increased
17.7% to $18,472,791 from $15,686,094 for the comparable period in the prior
fiscal year. The Company's net revenues for the current year represent shipments
of its new line of network computers, which was introduced at the end of June
1996, and revenues earned from the first licensing agreements for its netOS
operating system software for network computing devices. Net revenues for the
nine months ended March 31, 1996 represent shipments of the Company's X terminal
product line, which the Company marketed and manufactured prior to the
introduction of its network computers. The Company is subject to significant
variances in its quarterly operating results because of the fluctuations in the
timing of the receipt of large orders.
The Company's gross profit as a percentage of net revenues increased to
36.9% and 33.2% for the three and nine months ended March 31, 1997,
respectively, from 28.1% and 24.4%, respectively, for the comparable three- and
nine-month periods of the prior fiscal year. The improvement was a result of
achieving higher gross margins on the network computer product line, despite
comparatively lower selling prices, and from the addition of software licensing
revenues. The Company anticipates that gross margins will vary from quarter to
quarter depending on the source of the Company's business, including the
percentage of revenue derived from hardware and software. The gross profit
margin also varies in response to competitive market conditions as well as
periodic fluctuations in the cost of memory and other significant components.
The market in which the Company competes remains very competitive, and although
the Company intends to continue its efforts to reduce the cost of its products,
there can be no
certainty that the Company will not be required to reduce prices of its products
without compensating reductions in the cost to produce its products in order to
increase its market share or to meet competitors' price reductions.
Operating expenses for the three and nine months ended March 31, 1997
were $1,836,868 and $4,975,221, respectively. These figures represent increases
from operating expenses of $1,082,571 and $2,815,943, respectively, in the
comparable periods of the prior fiscal year. Sales and marketing expenses
increased by $401,669 to $993,660 for the three months ended March 31, 1997 as
compared to $591,991 for the prior year and by $1,334,608 to $2,776,150 from
$1,441,542 for the nine-month period then ended. These increases were the result
of significantly increasing the Company's sales and marketing staff, including
opening new sales offices in the United States and in Europe, and increased
expenditures for advertising and public relations. Research and development
expenses for the three months ended March 31, 1997 increased by 109.4% or
$141,123 to $404,712 from $193,207 in the comparable period of the prior year.
For the nine months ended March 31, 1997, research and development expenses
increased 98.7% or $480,981 to $967,824 from $486,843 as the Company expanded
its investment in engineering resources to develop, adapt or acquire
technologies complementary to its current business that will expand the market
for its current and future products. General and administrative expenses
increased to $438,496 for the three months ended March 31, 1997 from $297,373 in
the comparable period in the prior year. For the nine-month period ended March
31, 1997, general and administrative expenses increased from $887,558 to
$1,231,247 due to an increase in corporate staff relating to the formation of
the Company's new subsidiary, Information Technology Consulting, Inc.
Operating income increased to $410,408 for the three-month period ended
March 31, 1997 from an operating loss of $49,280 for the comparable period in
the previous fiscal year. The increase in operating income for the period is the
result of higher net revenues and higher gross profit margins, which were
partially offset by increased operating expenses. For the nine months ended
March 31, 1997, the Company's operating income increased from $1,014,224 to
$1,165,042, as a result of higher net revenues and higher gross profit margins
which were partially offset by increased investments in the Company's sales and
marketing and research and development expenses as well as increased general and
administrative expenses.
Net interest income decreased in the nine month period ended March 31,
1997 due to lower interest rates and investment balances and higher inventory
and accounts receivable balances.
The effective income tax rates were approximately 35.5% and 33.8% in the
three- and nine-month periods ended March 31, 1997 as compared to 36.0% and
36.4% in the comparable periods of the prior fiscal year due to the
implementation of tax planning strategies.
For the three months ended March 31, 1997, net income increased fifty-
fold to $281,033 from $5,057 for the comparable period in the prior year. The
increase in net income resulted from significant increases in revenues and in
gross profit percentages, which was partially offset by increased operating
expenses during the period, as well as lower net interest income. For the nine
months ended March 31, 1997, net income increased 10.3% to $837,299 from
$759,109 in the comparable period of the prior year. The increase was due to
higher revenues and higher gross margins, which was partially offset by
increased operating expenses.
Forward-Looking Statements
The foregoing "Management's Discussion and Analysis of Financial
Condition and Results of Operations" contains forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995. These
statements are subject to certain risks and uncertainties, including, but not
limited to, quarterly fluctuations in operating results, general economic
conditions affecting the demand for computer products, the timing of significant
orders, the timing and acceptance of new product introductions including the
Company's line of network computers and operating system software, the mix of
distribution
channels through which the Company's products are sold, increased competition in
the desktop computer market, including the network computer market, the failure
to reduce product costs or maintain quality, delays in the receipt of key
components, seasonal patterns of spending by customers, continued government
funding of projects for which the Company is a subcontractor and the Company's
ability, directly and through its wholly-owned subsidiary, to complete strategic
acquisitions. The Company does not undertake to update any forward-looking
statements made herein.
Liquidity and Capital Resources
At March 31, 1997, the Company had net working capital of approximately
$10,166,000 composed primarily of cash and cash equivalents, accounts receivable
and inventory. The Company's principal sources of liquidity included
approximately $1,766,854 of cash and cash equivalents and a $5,000,000 bank line
of credit facility, which was fully available as of March 31, 1997.
Cash and cash equivalents and short-term investments decreased by
approximately $933,000 during the nine-month period ended March 31, 1997,
primarily as a result of higher inventory and accounts receivable balances, as
well as significant investments by the Company in licensing technologies in
connection with the development of the network computer line.
The Company used approximately $1,333,000 in cash from operating
activities in the nine months ended March 31, 1997 compared to providing
$1,268,000 during the comparable period of fiscal 1996 due to the higher working
capital required by the increased revenue levels in 1997.
The Company expects to fund current operations and other cash
expenditures, as well as any acquisitions, through the use of available cash,
cash from operations, funds available under its credit facility, possible new
sources of debt and equity financing.
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
None
(b) Reports on Form 8-K:
None
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 thereunder duly authorized.
HDS NETWORK SYSTEMS, INC.
Date: May 15, 1997 By: /S/ ARTHUR R. SPECTOR
--------------------------
Arthur R. Spector, President and Chief
Executive Officer
Date: May 15, 1997 By: /S/ SCOTT HOLLAND
-------------------------
Scott Holland, Vice President of
Finance and Administration (Principal
Financial Officer and Principal
Accounting Officer)