1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-QSB Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 Quarter Ended September 30, 1998 Commission File No. 0-10385 VOICE CONTROL SYSTEMS, INC. (Name of small business issuer in its charter) DELAWARE 75-1707970 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 14140 MIDWAY ROAD DALLAS, TEXAS 75244 (972) 726-1200 (Address of principal executive (Registrant's telephone offices) 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 twelve 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. X Yes No --- --- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 13,654,553 shares of Common Stock, $.01 par value outstanding at September 30, 1998. 2 VOICE CONTROL SYSTEMS, INC. FORM 10-QSB QUARTERLY REPORT PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to S.E.C. rules and regulations although the Company believes the disclosures made are adequate to make the information presented not misleading, and in the opinion of management, all adjustments have been reflected which are necessary for a fair statement of the information shown. 2 3 VOICE CONTROL SYSTEMS, INC. BALANCE SHEET (UNAUDITED) =============================================================================== ASSETS September 30, 1998 ------------- CURRENT ASSETS: Cash and cash equivalents $ 6,460,519 Accounts receivable (net of $368,000 allowance for doubtful accounts) (Note 5) 3,985,055 Inventory 655,356 Prepaid expenses 367,262 ------------ TOTAL CURRENT ASSETS 11,468,192 NET PROPERTY AND EQUIPMENT 1,628,074 GOODWILL (NOTE 7) 1,176,393 OTHER ASSETS 125,804 ------------ $ 14,398,463 ============ LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT: Accounts payable and accrued expenses (Note 3) $ 1,449,369 Deferred revenue 570,486 ------------ TOTAL CURRENT LIABILITIES 2,019,855 LONG TERM DEBT 18,283 ------------ TOTAL LIABILITIES 2,038,138 ------------ COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY Preferred stock; $1.00 par value; 300,000 shares authorized; none issued and outstanding -- Common stock, $.01 par value: 20,000,000 shares authorized; 13,864,953 issued and 13,654,553 outstanding 136,545 Paid-in capital 46,666,192 Treasury stock (443,881) Receivable from shareholders (70,010) Deficit (33,928,521) ------------ TOTAL STOCKHOLDERS' EQUITY 12,360,325 $ 14,398,463 ============ See accompanying notes to financial statements 3 4 VOICE CONTROL SYSTEMS, INC. STATEMENTS OF OPERATIONS (UNAUDITED) =============================================================================== Three Months Nine Months Ended September 30, Ended September 30, 1998 1997 1998 1997 ----------- ----------- ----------- ----------- SALES (NOTE 5) .............................. $ 3,688,532 $ 2,021,095 $11,528,518 $10,285,977 COST OF SALES ............................... 597,977 450,197 2,340,290 2,146,296 ----------- ----------- ----------- ----------- GROSS PROFIT ................................ 3,090,555 1,570,898 9,188,228 8,139,681 COSTS AND EXPENSES: Research and development .................... 1,304,431 1,323,401 4,008,922 3,918,516 Selling, general and administrative ......... 2,620,235 1,737,193 8,194,579 5,230,499 Other interest expense (Income), net ........ (96,089) (189,045) (381,260) (570,703) Acquired in process resarch and development (Note 7) ................. 0 0 11,298,128 0 ----------- ----------- ----------- ----------- TOTAL COSTS AND EXPENSES .................... 3,828,577 2,871,549 23,120,369 8,578,312 ----------- ----------- ----------- ----------- NET (LOSS) BEFORE TAXES ..................... (738,022) (1,300,651) (13,932,141) (438,631) INCOME TAXES (NOTE 4) ....................... 0 0 0 10,750 ----------- ----------- ----------- ----------- NET LOSS .................................... $ (738,022) $(1,300,651) $(13,932,141) $ (449,381) =========== =========== =========== =========== NET (LOSS) PER SHARE: BASIC (NOTE 2) .............................. $ ( 0.05) $ (0.12) $ (1.10) $ (0.04) =========== =========== =========== =========== DILUTED (NOTE 2) ............................ $ (0.05) $ (0.12) $ (1.10) $ (0.04) =========== =========== =========== =========== WEIGHTED AVERAGE OUTSTANDING SHARES: BASIC (NOTE 2) .............................. 13,635,887 11,207,332 12,701,649 11,126,715 =========== =========== =========== =========== DILUTED (NOTE 2) ............................ 13,635,887 11,207,332 12,701,649 11,126,715 =========== =========== =========== =========== See accompanying notes to financial statements 4 5 VOICE CONTROL SYSTEMS, INC. STATEMENTS OF CASH FLOWS (UNAUDITED) ================================================================================ Nine months Ended September 30, 1998 1997 -------------- -------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (13,932,141) $ (449,381) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: In process resarch & development 11,298,128 Depreciation and amortization 699,832 379,942 Changes in operating assets and liabilities: Accounts receivable 107,180 (526,065) Inventory (197,314) (39,995) Prepaid expenses (182,800) (83,725) Other assets (46,872) (103,161) Accounts payable and accrued expenses (96,631) 35,688 Deferred revenue (649,941) (720,193) -------------- -------------- Net cash used in operating activities (2,906,815) (1,506,890) NET CASH USED IN INVESTING ACTIVITIES: Capital expenditures (408,668) (277,665) Acquisition of Purespeech (Note 7) (2,140,330) -- -------------- -------------- Net cash used in investing activities (2,548,998) (277,665) CASH FLOWS FROM FINANCING ACTIVITIES: Note payable 18,283 -- Proceeds from note receivable -- 48,745 Retirement of note payable (1,500,000) Treasury stock purchased (368,568) -- Proceeds from exercise of stock options 1,098,638 357,329 -------------- -------------- Net cash provided by (used in) financing activities (751,647) 406,074 Net decrease in cash and cash equivalents (6,207,460) (1,378,481) Cash and cash equivalents at beginning of year 12,667,979 15,226,824 -------------- -------------- Cash and cash equivalents at September 30 $ 6,460,519 $ 13,848,343 ============== ============== Supplemental disclosures of cash flow information Interest paid $ -- $ 302 Conversion of debt and interest by an affiliate to 1,300,694 shares of stock -- 1,195,078 See accompanying notes to financial statements 5 6 VOICE CONTROL SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (UNAUDITED) ================================================================================ 1. BUSINESS Voice Control Systems, Inc. (the "Company" or "VCS") engages in the design of voice recognition systems that allow for the voice control of electronic machines and/or devices. Operating results for the nine months ending September 30, 1998 are not necessarily indicative of the expected results for the year. The unaudited financial statements include all adjustments, consisting primarily of normal recurring accruals, which management considers necessary for a fair presentation of such information. 2. PER SHARE INFORMATION Net income (loss) per share is computed based upon the weighted average number of outstanding shares of common stock. The Financial Accounting Standards Board recently adopted, SFAS No. 128, Earnings Per Share (SFAS 128). SFAS 128 requires a calculation of book "Basic" and "Diluted" earnings per share. Basic earnings per share includes no dilution for common stock equivalents. 3. ACCOUNTS PAYABLE AND ACCRUED EXPENSES Accounts payable and accrued expenses consist of the following at September 30, 1998: Accounts payable $ 536,441 Accrued expenses 912,928 ------------ $ 1,449,369 4. INCOME TAXES The net operating loss (NOL) carryforwards of the Company expire from 1998 to 2012 and total approximately $36,620,000 as of September 30, 1998. The Company has provided an allowance against its entire deferred tax asset relating primarily to NOL carryforwards of approximately $12,450,000 since management cannot determine that it is more likely than not that the deferred tax asset will be realized. Approximately $1,225,000 in NOL carryforwards expired for the year ended December 31, 1997. In connection with its merger and acquisition activity the company and its predecessors have experienced an ownership change as defined by Internal Revenue Code 382 the effect of such changes limits the use of the Company's NOL in future years to approximately $1,405,000 annually. Any portion of an NOL limited by IRC 382 not used in a given year can be carried forward to subsequent years. 6 7 VOICE CONTROL SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (UNAUDITED) ================================================================================ The Company has provided an allowance for its entire deferred tax asset as its realization is dependent upon future generation of taxable income since management can not determine that it is more likely than not that the deferred tax asset will be realized. Until such realization can be reasonably determined based on established sources of earnings sufficient to utilize the NOL carryforward, management will continue to provide an allowance for the entire deferred tax asset. The following reconciles income tax expense at the federal statutory rate to the actual tax expense for the nine months ended September 30: 1998 1997 ------------- ------------ Income taxes at the statutory rate $ -- $ -- State taxes based on income -- -- Effect on taxes resulting from: Utilization of NOL carryforwards -- -- Federal Alternative Minimum Taxes -- 10,750 ------------- ------------ $ -- $ 10,750 ============= ============ 5. MAJOR CUSTOMERS Three customers accounted for 21%, 20%, and 10% of total sales revenue for the nine months ended September 30, 1998. Three customers accounted for 29%, 15% and 10% of total sales revenue for the nine months ended September 30, 1997. The Company's largest customer was also the holder of its short-term convertible debt. The promissory note and accrued interest was converted to 1,300,694 shares of common stock on January 1, 1997. Accounts receivable from the three largest customers were 21%, 13% and 13% of the total receivable balance at September 30, 1998. 7 8 VOICE CONTROL SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (UNAUDITED) ================================================================================ 6. NEW ACCOUNTING PRONOUNCEMENT In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income". This statement establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners. Among other disclosures, SFAS 130 requires that all Items that are required to be recognized under current accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. SFAS 130 is effective for financial statements for periods beginning after December 15, 1997 and requires comparative information for earlier years to be restated. The adoption of SFAS 130 had no effect on the financial statements of the Company. In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information" which is effective for the Company for the year ending December 31, 1998. This statement establishes standards for the way public business enterprises report information about operating segments in annual financial statements and requires these enterprises report selected information about operating segments in interim financial reports issued to shareholders. The Company is currently evaluating the impact that the adoption of SFAS 131 will have on its consolidated financial statements. 7. BUSINESS ACQUISITION On April 14, 1998 Voice Control Systems, Inc acquired 100% of the common and preferred stock of Purespeech, Inc. in exchange for 2,016,920 shares of Common Stock and cash of $2,140,000. This includes the conversion of PureSpeech warrants to 317,608 of VCS warrants. The transaction was accounted for using the purchase method of accounting. The preliminary allocation of the purchase price is as follows: Goodwill $ 1,415,000 Net value of remaining assets 317,000 Acquired in process R&D 11,298,000 ------------ $ 13,030,000 The acquired research and development was charged to expense as research and development costs. Goodwill is being amortized over its estimated useful life of five years. 8 9 PART I - FINANCIAL INFORMATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION RESULTS OF OPERATIONS Nine months Ended September 30, 1998 vs. September 30, 1997 Sales increased 12% from $10,286,000 during the nine months ending September 30, 1997 to $11,529,000 during the nine months ending September 30, 1998. Three customers, Dialogic Corporation, OKI Telecom and Intervoice accounted for 21%, 20%, and 10% respectively, of total sales for the nine months ending September 30, 1998. Dialogic Corporation, Glenayre and OKI Telecom accounted for 29%, 15%, and 10% respectively, of total sales for the nine months ending September 30, 1997. Royalty, development and license fees, which increased 61% over the nine months ending September 30, 1997, were 45% of total revenues for the nine months ending September 30, 1998. Hardware sales, which decreased 9% over the nine months ending September 30, 1997, were 51% of revenues in the nine months ending September 30, 1998. The decrease in hardware sales is offset by the increase in royalties, development and license fees as the company continues to transition from primarily providing hardware to primarily providing software. Cost of sales includes the cost of components and subcontracted manufacturing related to hardware products. Gross profit as a percent of sales increased from 79% to 80% in the nine months ending September 30, 1997 and 1998 as a result of the decrease in hardware sales. Research and development expenses increased 2% from $3,919,000 in the nine months ending September 30, 1997 to $4,009,000 in the nine months ending September 30, 1998. This increase is a result of the merger with PureSpeech. Selling, general, and administrative expenses increased 57% from $5,230,000 in the nine months ending September 30, 1997 to $8,195,000 in the nine months ending September 30, 1998. Additional sales personnel, operations and administrative staff have been added to help support a growing customer base of firms utilizing speech recognition technology with the addition of the PureSpeech product line to VCS. On April 14, 1998 VCS acquired 100 percent of the common stock and common stock equivalents of PureSpeech in return for VCS stock. Pursuant to the terms of the agreement, all shares of PureSpeech common and preferred stock outstanding immediately prior to the closing of the Merger were converted into and exchanged for 1,316,555 shares of VCS Common Stock. In addition, PureSpeech shareholder debt assumed by VCS was converted into 322,878 shares of VCS common stock. Options, warrants and other rights to acquire PureSpeech common stock were converted to options and warrants to acquire 619,561 shares of VCS common stock. The Merger was accounted for as a purchase with VCS acquiring PureSpeech in the acquisition. The 9 10 acquired in process research and development is expensed in the accompanying financial statements. The net operating loss (NOL) carryforwards of the Company expires from 1998 to 2012 and total approximately $36,620,000 as of September 30, 1998. The Company has provided an allowance against its entire deferred tax asset relating primarily to NOL carryforwards of approximately $12,450,000 since management cannot determine that it is more likely than not that the deferred tax asset will be realized. Approximately $1,225,000 in NOL carryforwards expired for the year ended December 31, 1997. In connection with its merger and acquisition activity the company and its predecessors have experienced ownership changes as defined by Internal Revenue Code 382 the effect of such changes limits the use of the Company's NOL in future years to approximately $1,405,000 annually. Any portion of an NOL limited by IRC 382 not used in a given year can be carried forward to subsequent years Three Months Ended September 30, 1998 vs. September 30, 1997 Sales increased 83% from $3,689,000 during the three months ending September 30, 1997 to $2,021,000 during the three months ending September 30, 1998. Four customers OKI Telecom, Inc., Dialogic Corporation, IBM, and Intel accounted for 19%, 18%, 14% and 14% respectively, of total sales for the three months ending September 30, 1998. OKI Telecom, Glenayre, and Dialogic Corporation accounted for 24%, 18% and 14%, respectively, of total sales for the three months ending September 30, 1997. Royalty, development and license fees, which increased 157% over the three months ending September 30, 1997, were 52 % of total revenues for the three months ending September 30, 1998. Hardware sales, which increased 39% over the three months ending September 30, 1997, were 42% of revenues in the three months ending September 30, 1998. Cost of sales includes the cost of components and subcontracted manufacturing related to hardware products. Gross profit as a percent of sales increased from 78% to 84% for the three months ending September 30, 1997 and 1998 as a result of the increased margin on software sales. Research and development expenses decreased 1% from $1,323,000 for the three months ending September 30, 1997 to $1,304,000 for the three months ending September 30, 1998. Selling, general, and administrative expenses increased 51% from $1,737,000 for the three months ending September 30, 1997 to $2,620,000 for the three months ending September 30, 1998. The increase is due to the introduction of the Company's speech enabled auto-attendant product and additions to the selling, marketing and administrative areas due to the PureSpeech acquisition. On April 14, 1998 VCS acquired 100 percent of the common stock and common stock equivalents of PureSpeech in return for VCS stock. Pursuant to the terms of the agreement, all shares of PureSpeech common and preferred stock outstanding immediately prior to the closing of the Merger were converted into and exchanged for 1,316,555 shares of VCS Common Stock. 10 11 In addition, PureSpeech shareholder debt assumed by VCS was converted into 322,878 shares of VCS common stock. Options, warrants and other rights to acquire PureSpeech common stock were converted to options and warrants to acquire 619,561 shares of VCS common stock. The Merger was accounted for as a purchase with VCS acquiring PureSpeech in the acquisition. The acquired in process research and development is expensed in the accompanying financial statements. 11 12 LIQUIDITY AND CAPITAL RESOURCES The Company's principal cash requirements to date have been to fund working capital and capital expenditures in order to support its sales growth. Net working capital at September 30, 1998 was $9,448,000. In the past, the Company's working capital needs were financed primarily through cash flow from operations and proceeds from the exercise of warrants and stock options. At September 30, 1998, the Company held $6,461,000 in cash and cash equivalents. Cash and cash equivalents are invested in institutional cash investment accounts with preservation of capital being the primary consideration. All investments currently have overnight liquidity. Historically, the Company's primary source of liquidity has been the timely collection of its accounts receivable. The average day's sales in accounts receivable was 97 days as of September 30, 1998. The Company's inventory as of September 30, 1998 was approximately $655,000 net of reserves of approximately $219,000 that have been established for obsolescence. The Company maintained $18,000 debt obligations as of September 30, 1998. The Company's capital expenditures were $142,000 for the three months ended September 30, 1998. The expenditures were primarily for computer equipment. VCS believes that its existing sources of liquidity and funds generated by operations will be sufficient to provide the capital resources necessary to support its increased operating needs and finance continued growth in the foreseeable future. 12 13 PART II - OTHER INFORMATION ITEM 6. XHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 27 Financial Data Schedule (b) Reports on Form 8-K No reports were filed during the period. 13 14 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. VOICE CONTROL SYSTEMS, INC. Dated: November 12, 1998 By: /s/ Peter J. Foster ------------------- Peter J. Foster Chief Executive Officer and President /s/ Kim S. Terry ---------------- Kim S. Terry Principal Financial and Accounting Officer 14 15 Exhibit Index Exhibit Number Description - ------- ----------- 27 Financial Data Schedule