UNITED STATES 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 September 30, 2003
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OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission File No. 0-5265
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SCAN-OPTICS, INC.
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(Exact name of registrant as specified in its charter)
Delaware 06-0851857
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(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
169 Progress Drive, Manchester, CT 06040
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(Address of principal executive offices) Zip Code
(860) 645-7878
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(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. ( X ) YES ( ) NO
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). ( ) YES ( X ) NO
The number of shares of common stock, $.02 par value, outstanding as of November
1, 2003 was 7,439,732.
1
SCAN-OPTICS, INC.
FORM 10-Q
I N D E X
PAGE
NO.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.................................................................... 3
Item 2. Management's Discussion and Analysis of Consolidated Financial Condition
and Results of Operations........................................................... 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk............................... 19
Item 4. Controls and Procedures.................................................................. 19
PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K........................................................ 20
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(thousands, except share data) September 30, December 31,
2003 2002
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(UNAUDITED)
Assets
Current Assets:
Cash and cash equivalents $ 399 $ 274
Accounts receivable less allowance of $1,080 at
September 30, 2003 and $1,574 at December 31, 2002 6,658 5,554
Unbilled receivables - contracts in progress 244 377
Inventories 8,555 9,139
Prepaid expenses and other 1,014 591
--------------------------
Total current assets 16,870 15,935
Plant and equipment:
Equipment 3,731 8,836
Leasehold improvements 4,009 5,209
Office furniture and fixtures 614 725
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8,354 14,770
Less allowances for depreciation and amortization 7,310 13,456
--------------------------
1,044 1,314
Goodwill 9,040 9,040
Other assets 117 117
--------------------------
Total Assets $27,071 $26,406
==========================
3
(thousands, except share data) September 30, December 31,
2003 2002
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(UNAUDITED)
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 2,860 $ 2,454
Notes payable 1,500 1,500
Salaries and wages 1,200 958
Taxes other than income taxes 373 501
Income taxes 47 45
Customer deposits 1,319 1,308
Deferred revenues 2,648 2,217
Other 1,647 1,669
----------------------------
Total current liabilities 11,594 10,652
Notes payable 7,989 9,042
Other liabilities 1,925 1,640
Mandatory redeemable preferred stock, par value $.02
per share, authorized 3,800,000 shares;
3,800,000 issued and outstanding 3,800 3,800
Stockholders' Equity
Preferred stock, par value $.02 per share,
authorized 1,200,000 shares; none
issued or outstanding
Common stock, par value $.02 per share,
authorized 15,000,000 shares;
issued, 7,439,732 shares at September 30, 2003
and December 31, 2002 149 149
Common stock Class A Convertible, par
value $.02 per share, authorized 3,000,000
shares; available for issuance 2,145,536
shares; none issued or outstanding
Capital in excess of par value 38,354 38,354
Accumulated retained earnings deficit (33,245) (33,667)
Accumulated other comprehensive loss (849) (918)
----------------------------
4,409 3,918
Less cost of common stock in treasury,
413,500 shares 2,646 2,646
----------------------------
Total stockholders' equity 1,763 1,272
----------------------------
Total Liabilities and Stockholders' Equity $ 27,071 $ 26,406
============================
See accompanying notes.
4
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended Nine Months Ended
September 30 September 30
(thousands, except share data) 2003 2002 2003 2002
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Revenues
Hardware and software $ 3,451 $ 2,799 $ 11,752 $ 9,095
Professional services 1,241 1,628 3,864 4,962
Access services 2,673 2,741 7,966 8,777
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Total revenues 7,365 7,168 23,582 22,834
Costs of Revenue
Hardware and software 2,410 1,785 7,348 5,999
Professional services 645 754 2,097 2,182
Access services 2,172 2,105 6,683 6,671
-------------------------------------- ----------------------------------
Total costs of revenue 5,227 4,644 16,128 14,852
Gross Margin 2,138 2,524 7,454 7,982
Operating Expenses
Sales and marketing 767 874 2,614 2,539
Research and development 207 323 986 1,389
General and administrative 900 879 2,729 2,754
Interest 185 203 667 642
-------------------------------------- ----------------------------------
Total operating expenses 2,059 2,279 6,996 7,324
-------------------------------------- ----------------------------------
Operating income 79 245 458 658
Other income (expense), net (56) (5) 5 7
--------------------------------------- ----------------------------------
Income before income taxes 23 240 463 665
Income tax expense 11 20 41 61
-------------------------------------- ----------------------------------
Net Income $ 12 $ 220 $ 422 $ 604
====================================== ==================================
Basic earnings per share $ 0.00 $ 0.03 $ 0.06 $ 0.09
====================================== ==================================
Basic weighted-average common shares 7,026,232 7,026,232 7,026,232 7,026,232
Diluted earnings per share $ 0.00 $ 0.03 $ 0.05 $ 0.08
====================================== ==================================
Diluted weighted-average common shares 8,171,929 7,229,109 7,715,708 7,314,788
See accompanying notes.
5
SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Nine Months Ended
September 30
(thousands) 2003 2002
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Operating Activities
Net Income $ 422 $ 604
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation 259 314
Amortization of customer service inventory and
software license 1,532 1,800
Disposal of fixed assets 46
Changes in operating assets and liabilities:
Accounts receivable and unbilled receivables (971) 377
Inventories (948) (1,758)
Prepaid expenses and other (423) (28)
Accounts payable 406 (531)
Accrued salaries and wages 242 (90)
Taxes other than income taxes (128) (137)
Income taxes 2
Deferred revenues 431 (85)
Customer deposits 11 701
Other 360 246
----------------------------
Net cash provided by operating activities 1,241 1,413
Investing Activities
Purchases of plant and equipment, net (63) (72)
----------------------------
Net cash used by investing activities (63) (72)
Financing Activities
Proceeds from borrowings 5,300 2,626
Principal payments on borrowings (6,353) (4,876)
----------------------------
Net cash used by financing activities (1,053) (2,250)
Increase (decrease) in cash and cash equivalents 125 (909)
Cash and Cash Equivalents at Beginning of Period 274 1,662
----------------------------
Cash and Cash Equivalents at End of Period $ 399 $ 753
============================
See accompanying notes.
6
NOTE 1 - Basis of Presentation and Significant Accounting Policies
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The accompanying unaudited interim consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the nine month period ended September 30,
2003 are not necessarily indicative of the results that may be expected for the
year ending December 31, 2003. For further information, refer to the
consolidated financial statements and footnotes thereto included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2002.
Certain 2002 amounts have been reclassified to conform to current year
presentation.
New Accounting Pronouncements
In May 2003, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150").
This statement establishes standards for classifying and measuring, as
liabilities, certain financial instruments that embody obligations of the issuer
and have characteristics of both liabilities and equity. SFAS 150 generally
requires liability classification for financial instruments, including
mandatorily redeemable equity instruments and other non-equity instruments
requiring, from inception, the repurchase by the issuer of its equity shares.
This statement is applicable to the Company as of the beginning of the first
interim financial reporting period beginning after June 15, 2003. The adoption
of this Statement did not have a significant effect on the Company's financial
position as of September 30, 2003 or on the results of operations for the
three-month or nine-month periods ending September 30, 2003.
In May 2003, the FASB's Emerging Issues Task Force defined the scope of Issue
00-21, "Revenue Arrangements With Multiple Deliverables" ("EITF No. 00-21") and
its interaction with other authoritative literature. This statement is
applicable to agreements entered into for reporting periods beginning after June
15, 2003 and requires companies with revenue arrangements including multiple
deliverables to be divided into separate units of accounting for revenue
recognition purposes, if the deliverables in the arrangement meet certain
criteria, including standalone value to the customer, objective and reliable
evidence of the fair value of the undelivered items exists and if the
arrangement includes a general right of return relative to the delivered item,
delivery or performance of the undelivered item is considered probable and
substantially in the control of the vendor. The adoption of this Statement did
not have a significant effect on the Company's financial position as of
September 30, 2003 or on the results of operations for the three-month or
nine-month periods ending September 30, 2003.
7
Stock Based Compensation
The Company grants stock options to key employees and members of the Board of
Directors with an exercise price equal to the fair value of the shares on the
date of grant. The Company accounts for stock option grants in accordance with
APB Opinion No. 25, Accounting for Stock Issued to Employees, and, accordingly,
recognizes no compensation expense for the stock option grants. Therefore, the
Company has elected the disclosure provisions only of FASB Statement No. 123.
For the purpose of pro forma disclosures, the estimated fair value of the stock
options is expensed ratably over the vesting period, which is 36 months for key
employees and 6 months for the Board of Directors.
In December 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") 148, "Accounting for
Stock-Based Compensation--Transition and Disclosure". SFAS 148 amends the
disclosure requirements of SFAS 123 to require prominent disclosures in both
annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The following table illustrates the effect on net income and income per
share if the Company had applied the fair value recognition provisions of SFAS
No. 123:
For the three months ended For the nine months ended
September 30 September 30
(thousands, except per share amounts) 2003 2002 2003 2002
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Net income, as reported $ 12 $ 220 $ 422 $ 604
Stock option (income) expense (25) 28 (38) (223)
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Pro forma net income (loss) $ (13) $ 248 $ 384 $ 381
=====================================================================
Basic earnings per share, as reported $ .00 $ .03 $ .06 $ .09
Stock option expense .00 .00 (.01) (.03)
---------------------------------------------------------------------
Pro forma basic earnings per share $ .00 $ .03 $ .05 $ .06
=====================================================================
Diluted earnings per share, as reported $ .00 $ .03 $ .05 $ .08
Stock option expense .00 .00 (.01) (.03)
---------------------------------------------------------------------
Pro forma diluted earnings per share $ .00 $ .03 $ .04 $ .05
=====================================================================
8
NOTE 2 - Inventories
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The components of inventories were as follows:
September 30 December 31
(thousands) 2003 2002
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Finished goods $ 58 $ 56
Work-in-process 1,250 1,325
Service parts 3,322 3,715
Materials and component parts 3,925 4,043
------------------------------------
$ 8,555 $ 9,139
====================================
NOTE 3 - Credit Arrangements
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Notes payable reflect borrowings under a credit agreement ("Agreement") with
Patriarch Partners, LLC. ("Patriarch"). The Agreement allows for borrowings
under a revolving line of credit facility of $10 million and an initial term
loan of $2 million.
As of December 31, 2002, the Company executed an amendment to the loan with
Patriarch to modify the capital expenditure covenant, from a maximum of $50,000
per quarter, to a maximum of $375,000 per year.
The outstanding borrowings at September 30, 2003 and December 31, 2002 were $9.5
million and $10.5 million, respectively. The revolving line of credit has been
classified as long term, with the exception of $1.5 million classified as
current, since management has the ability to maintain the September 30, 2003
outstanding balance through the next fiscal year. All outstanding borrowings
under the Agreement will be due and payable as of December 31, 2004. The
available balance on the outstanding borrowings was $2.1 million and $1.5
million at September 30, 2003 and December 31, 2002, respectively. The weighted
average interest rate for the third quarter of 2003 was 4.9% compared to 5.6% in
2002.
The Agreement contains a provision that allows for the quarterly recapture of
fifty percent of the excess cash flow to be applied to the term loan. Excess
cash flow is based upon the calculation of consolidated cash flow (the sum of
earnings from operations before income taxes and interest plus depreciation and
amortization minus cash taxes paid minus capital expenditures) minus the
aggregate amount of consolidated financial obligations (payments on indebtedness
or payments on capitalized leases). The recapture of excess cash flow for the
year ending December 31, 2002 was $.4 million, which was paid in the third
quarter of 2003 and reduced the term loan balance to $1.6 million.
As the interest rates are variable, the carrying value of the notes payable
approximates its fair value. The notes payable are secured by all of the
Company's assets.
9
NOTE 4 - Income Taxes
At September 30, 2003, the Company had U.S. federal and state net operating loss
carryforwards of approximately $28,264,000 and $27,048,000, respectively. The
U.S. federal and state net operating loss carryforwards expire through 2015. At
September 30, 2003, the Company had approximately $3,549,000 and $800,000 of net
operating loss carryforwards for the United Kingdom and Germany, respectively,
which expire through 2007. At December 31, 2002, the Company had U.S. federal
and state net operating loss carryforwards of approximately $27,200,000 and
$26,000,000, respectively. At December 31, 2002, the Company had approximately
$226,000, $3,400,000 and $800,000 of net operating loss carryforwards for
Canada, the United Kingdom and Germany, respectively. For financial reporting
purposes, a valuation allowance has been recorded to fully offset deferred tax
assets relating to U.S. federal, state, and foreign net operating loss
carryforwards and other temporary differences.
NOTE 5 - Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per
share:
Three Months Ended Nine Months Ended
September 30 September 30
2003 2002 2003 2002
------------------------------------------------------------------------
Numerator:
Net earnings $ 12 $ 220 $ 422 $ 604
========================================================================
Denominator:
Denominator for basic earnings
per share (weighted-average shares) 7,026,232 7,026,232 7,026,232 7,026,232
Effect of dilutive securities:
Employee stock options 1,145,697 202,877 689,476 288,556
------------------------------------------------------------------------
Denominator for diluted earnings
per share (adjusted weighted-average
shares and assumed conversions) 8,171,929 7,229,109 7,715,708 7,314,788
========================================================================
Basic earnings per share $ .00 $ .03 $ .06 $ .09
========================================================================
Diluted earnings per share $ .00 $ .03 $ .05 $ .08
========================================================================
10
NOTE 6 - Comprehensive Income
- ------
The components of comprehensive income (loss) for the three and nine months
ended September 30, 2003 and 2002 are as follows:
Three Months Ended Nine Months Ended
September 30 September 30
(thousands) 2003 2002 2003 2002
- -------------------------------------------------------------------------------------------------------------------
Net Income $ 12 $ 220 $ 422 $ 604
Foreign currency translation adjustments (34) 18 69 71
---------------------------------------------------------------
Comprehensive income (loss) $ (24) $ 238 $ 491 $ 675
===============================================================
The components of accumulated comprehensive loss at September 30, 2003 and
December 31, 2002 are as follows:
September 30 December 31
(thousands) 2003 2002
- -------------------------------------------------------------------------------------------
Foreign currency translation adjustments $ (849) $ (918)
--------------------------------------
Accumulated comprehensive loss $ (849) $ (918)
======================================
NOTE 7 - Segment Information
- ------
The Company views its business in three distinct revenue categories: Solution
and products sales, Access services, and Contract manufacturing services.
Revenues are used by management as a guide to determine the effectiveness of the
individual segment. The Company manages its operating expenses through a
traditional functional perspective and accordingly does not report operating
expenses on a segment basis.
Three Months Ended Nine Months Ended
September 30 September 30
(thousands) 2003 2002 2003 2002
- -------------------------------------------------------------------------------------------------------------------
Revenues
Solutions and products $ 4,446 $ 4,129 $ 15,290 $ 12,988
Access services 2,673 2,741 7,966 8,777
Contract manufacturing services 246 298 326 1,069
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11
Total revenues 7,365 7,168 23,582 22,834
Cost of solutions and products 3,055 2,539 9,445 8,181
Service expenses 2,172 2,105 6,683 6,671
---------------------------------------------------------------
Gross profit margin 2,138 2,524 7,454 7,982
Operating expenses
and other income, net 2,115 2,284 6,991 7,317
---------------------------------------------------------------
Income before income taxes $ 23 $ 240 $ 463 $ 665
===============================================================
Total expenditures for additions
to long-lived assets $ 3 $ 24 $ 63 $ 72
Certain 2002 amounts have been reclassified to conform to the current year
presentation.
The Solutions and Products Division includes the sale of hardware and software
products as well as professional services. Contract Manufacturing Services
provides assembly and test services under contracts with customers who develop
and sell a variety of equipment.
NOTE 8 - Bill and Hold Transactions
- ------
Revenues relating to sales of certain equipment (principally optical character
recognition equipment) are recognized upon acceptance, shipment, or installation
depending on the contract specifications. When customers, under the terms of
specific orders or contracts, request that the Company manufacture and invoice
the equipment on a bill and hold basis, the Company recognizes revenue based
upon an acceptance received from the customer. The Company recorded no bill and
hold revenue during the third quarter of 2003 and $2.3 million in the first nine
months of 2003. Revenues recorded during the first nine months of 2002 included
bill and hold transactions of $.9 million. Accounts receivable included bill and
hold receivables of $.7 million, and $1.1 million at September 30, 2003 and
December 31, 2002, respectively.
12
Item 2. Management's Discussion and Analysis of Consolidated Financial
Condition and Results of Operations.
Outlook
The forward-looking statements contained in this section and elsewhere in this
document are based on current expectations. Scan-Optics, Inc. (the "Company")
and its future operations are subject to a number of risks, including those
discussed below. The following list is not intended to be an exhaustive list of
all the risks to which the Company's business is subject, but only to highlight
certain substantial risks faced by the Company. Although the Company completed a
total debt restructuring effective December 31, 2001 (see Note 3 to the
consolidated financial statements for further information), the Company remains
highly leveraged and could be adversely affected by a significant increase in
interest rates or an inability to comply with financial covenants in its debt
agreements or a failure to extend or replace its existing debt agreements prior
to December 31, 2004. A one percent increase in the prime rate would increase
the annual interest cost on the outstanding loan balance at September 30, 2003
of approximately $9.5 million by $.1 million. All outstanding borrowings under
the Company's existing debt agreements will be due and payable as of December
31, 2004 and, as of that date, the Company will also be obligated to redeem from
its lender the Company's mandatorily redeemable non-voting preferred stock at a
redemption price equal to $3.8 million plus interest accrued on such amount from
December 31, 2001 through the date of redemption at an interest rate per annum
equal to the prime rate of interest in effect from time to time during such
period, plus 2% compounded annually. The Company's business could be adversely
affected by downturns in the domestic and international economy. The Company's
international sales and operations are subject to various international business
risks. The Company's revenues depend in part on contracts with various state or
federal governmental agencies, and could be adversely affected by patterns in
government spending. The Company faces competition from many sources, and its
products may be replaced with products relying on alternative technologies. The
Company's business could be adversely affected by technological changes.
The Company achieved net income of $12,000 in the third quarter of 2003 compared
to $.2 million in the third quarter of 2002. Net income for the nine months
ended September 30, 2003 was $.4 million compared to $.6 million for the
comparable period in 2002.
The Company has three major initiatives currently underway to improve revenue
growth and profitability. They are designed to emphasize the "Business of
Solutions" focus in targeted markets, introduce the Business Process Outsourcing
Service and expand the Access Services Division to include enterprise-wide
maintenance services. The inability of the Company to carry out these
initiatives may have a material adverse effect on revenue growth and earnings.
The first initiative is to provide cost-effective solutions through the
Company's development of target market data capture applications combined with
its high speed transports and archival systems. The Company has refined its
target market approach and has chosen to focus primarily on the government and
insurance markets, while continuing to address the
13
transportation, assessment, financial and order fulfillment markets. The Company
expects to continue to emphasize its "Business of Solutions" focus on these
targeted markets for the foreseeable future. As other market opportunities
emerge, the Company will evaluate the potential of using its products and
services to provide solutions in these new markets. The Company's revenue in the
solutions initiative increased $2.7 million or 35% from the first nine months of
2002 to 2003 and $.2 million or 7% in a comparison of the third quarter of 2003
vs. 2002, mainly due to an increase in the government market.
The second initiative, introduced in early 2003, is a Business Process
Outsourcing ("BPO") Service to capture images of documents for subsequent
document management, storage and retrieval. The Company's new BPO Services
provide a low-risk, cost-effective solution for customers with document imaging
needs. As increasing numbers of both government and commercial clients migrate
from paper-based filing systems to image-based storage and retrieval systems,
they are faced with the need to convert their existing paper files or to
outsource the activity. The BPO Services offer customers a high quality, turnkey
outsourcing solution utilizing the Company's proprietary hardware technology, as
well as its software skills, resources and process controls.
The third initiative, by our Access Services Division, is an expansion to
include enterprise-wide maintenance services for network and network-related
equipment. Leveraging off the experience it has gained through its many third
party agreements, Access Services is well positioned to expand maintenance
coverage and provide customers with "one number to call" for maintenance
services regardless of the equipment manufacturer. Through the division's 120
technical service representatives strategically located throughout the U.S., the
Company believes that it can provide high quality, cost-effective enterprise
maintenance to its existing customer base as well as new accounts.
While the Company is principally focused on improving the profitability of its
existing operations, the Company may consider acquiring key strategic products
or enterprises. Acquisitions will be considered based upon their individual
merit and benefit to the Company.
Results of Operations for the Three and Nine Months Ended September 30, 2003 vs.
2002
Total revenues increased $.7 million or 3% from the first nine months of 2002 to
the first nine months of 2003 and increased $.2 million or 3% from the third
quarter of 2002 to the third quarter of 2003.
Hardware and software revenues increased $2.7 million or 29% in the first nine
months of 2003 compared with the same period in 2002 and increased $.7 million
or 23% from the third quarter of 2002 compared to 2003. Compared to the first
nine months of 2002, North American sales increased $2.6 million or 29% and
increased $.5 million or 19% during the third quarter of 2003 compared to the
third quarter of 2002 mainly due to the increase in hardware sales to replace or
upgrade existing equipment at current customer sites. International sales
remained consistent with the first nine months of 2002 and the third quarter of
2002.
14
Professional services revenues decreased $1.1 million or 22% in the first nine
months of 2003 compared with the first nine months of 2002 and decreased $.4
million or 24% during the third quarter of 2003 compared to the third quarter of
2002. These decreases relate to the difficulties in the current United States
economy.
Access services revenues decreased $.8 million or 9% in the first nine months of
2003 compared with the first nine months of 2002 and decreased $.1 million or 2%
during the third quarter of 2003 compared to the third quarter of 2002. The
decrease in revenue is mainly due to decreases in the Company's proprietary
maintenance contracts as a result of lower maintenance rates for the latest
generation of the Series 9000 scanner, the 9000M, as compared to the earlier
Series 9000 scanner. The Company was also impacted by a few customers
discontinuing maintenance due to changes in their business or the use of other
technologies.
Cost of hardware and software increased $1.3 million or 22% in the first nine
months of 2003 compared to the first nine months of 2002 and increased $.6
million or 35% in the third quarter of 2003 compared to the third quarter of
2002. The gross margin was 37% for the first nine months of 2003, compared to
34% in the first nine months of the prior year. The gross margin was 30% during
the third quarter of 2003, compared to 36% in the third quarter of the prior
year. The changes in gross margin are mainly due to changes in product mix and a
decline in contract manufacturing volumes.
Cost of professional services decreased $.1 million in the first nine months of
2003 vs. 2002 and decreased $.1 million in the third quarter of 2003 compared to
the prior year. The gross margin was 46% for the first nine months and 48% for
the third quarter of 2003, compared to 56% in the first nine months and 54% in
the third quarter of 2002. The decrease in gross margin was mainly due to a
decline in new solutions sales, as well as fixed costs that exist to support a
higher volume of business.
Cost of Access Services remained flat for the first nine months of 2003 vs. 2002
and increased $.1 million in the third quarter of 2003 compared to the prior
year. The gross margin was 16% for the first nine months of 2003, compared to
24% in the first nine months of 2002. The gross margin was 19% during the third
quarter of 2003, compared to 23% in the third quarter of the prior year. The
decrease in margin is due to decreased Access Services revenue, which was only
partially offset by a decrease in expenses.
Sales and marketing expenses increased $.1 million in the first nine months of
2003 compared to the first nine months of 2002 and decreased $.1 million in the
third quarter of 2003 compared to the third quarter of 2002. The increase is
mainly in outside services related to the Company's new website as well as
increases in consulting services for recoverable monthly payments related to an
additional reseller in the Washington, D.C., area.
15
Research and development expenses decreased $.4 million from the first nine
months of 2002 and decreased $.1 million from the third quarter of 2002 mainly
due to a decrease in software license amortization related to the BlueBird
software agreement, which has been fully amortized.
General and administrative expenses remained consistent in the nine month and
third quarter comparison from 2003 vs. 2002.
Interest expense remained consistent with the first nine months of 2002 and the
third quarter of 2002. The weighted average interest rate for the first nine
months of 2003 was 5.1% compared to 5.6% in 2002.
Liquidity and Capital Resources
Cash and cash equivalents at September 30, 2003 increased $.1 million from
December 31, 2002 levels.
Total borrowings were $9.5 million or $1.1 million lower than the $10.6 million
level at December 31, 2002. The available balance on the line of credit was $2.1
million at September 30, 2003. As of September 30, 2003, the Company is in
compliance with all of the financial covenants. The Company anticipates meeting
its current obligations and resource needs through the funds generated through
operations. (See Note 3 for further details.) All outstanding borrowings under
the Company's credit agreements will be due and payable as of December 31, 2004
and, as of that date, the Company will also be obligated to redeem from its
lender the Company's mandatorily redeemable non-voting preferred stock. Although
the Company expects to extend or refinance this indebtedness and redeem the
preferred stock, there can be no assurance as to the availability or terms of
any such extension or refinancing. If the Company fails to extend or refinance
its existing indebtedness and redeem its preferred stock prior December 31,
2004, the Company's current lender has the right to exercise warrants to acquire
up to 33.20% of the Company's common stock and to convert its manditorily
redeemable non-voting preferred stock into voting preferred stock. It is
possible that the terms of any extension or refinancing of the indebtedness
could require the issuance by the Company of equity that would dilute current
stockholders.
Operating activities provided $1.2 million of cash in the first nine months of
2003, as compared to $1.4 million in the first nine months of 2002.
Non-cash expenses recorded during the first nine months of the year were $1.8
million, a decrease of $.3 million from the same period in 2002. These expenses
relate to disposal losses and depreciation of fixed assets (discussed in net
plant and equipment below) and amortization of customer service inventory and
software license.
Net accounts receivable and unbilled receivables at September 30, 2003 increased
$1 million from December 31, 2002
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due mainly to the increase in revenue from the fourth quarter of 2002 of $6.4
million to revenue of $7.4 million in the third quarter of 2003. The increase in
revenue of $1 million along with the timing of payments resulted in the increase
in accounts receivables.
Total inventories at September 30, 2003 decreased $.6 million from December 31,
2002. Total manufacturing inventories decreased $.2 million from the beginning
of the year mainly due to the timing of the 2003 fourth quarter build plan and
third quarter delivery of equipment. Customer service inventories decreased $.4
million mainly due to amortization of inventory.
Prepaid expenses and other increased $.4 million due to capitalized project
engineering costs recorded in the third quarter of 2003.
Net plant and equipment decreased $.3 million from December 31, 2002 mainly due
to depreciation expense reported during the first nine months of the year.
During 2003, the Company performed a physical inventory of all plant and
equipment and based on the results of these procedures wrote-off assets,
primarily fully depreciated assets, which are no longer used in operations. As a
result, the gross cost of these assets, as well as, the related accumulated
depreciation and amortization were reduced by $6.5 million. The impact of this
activity on 2003 operating results was a loss of approximately $46,000, which
was recognized during the third quarter.
Accounts payable increased $.4 million from December 31, 2002 due to the timing
of payments.
Salaries and wages increased $.2 million due mainly to an increase in the
vacation accrual that is expected to be utilized over the remainder of the year
and an increase in accrued commissions.
Taxes other than income taxes decreased $.1 million due to payments made for
sales and use taxes in various states and Goods and Services Tax in Canada.
Customer deposits were flat with December 31, 2002 balances.
Deferred revenues increased $.4 million due to an increase in annual billings
that were previously billed on a monthly basis.
Other liabilities were consistent with December 31, 2002 levels.
Critical Accounting Policies
Our critical accounting policies are discussed in Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations in our
Annual Report on Form 10-K for the year ended December 31, 2002. The preparation
of our financial statements requires us to make estimates that affect the
reported amounts of assets, liabilities, revenue and expenses and related
disclosures of contingent assets and liabilities. We base our accounting
estimates on historical experience and other factors that are believed to be
reasonable under the circumstances. However, actual results may vary from these
estimates under different assumptions or conditions.
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New Accounting Pronouncements
In May 2003, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150").
This statement establishes standards for classifying and measuring, as
liabilities, certain financial instruments that embody obligations of the issuer
and have characteristics of both liabilities and equity. SFAS 150 generally
requires liability classification for financial instruments, including
mandatorily redeemable equity instruments and other non-equity instruments
requiring, from inception, the repurchase by the issuer of its equity shares.
This statement is applicable to the Company as of the beginning of the first
interim financial reporting period beginning after June 15, 2003. The adoption
of this Statement did not have a significant effect on the Company's financial
position as of September 30, 2003 or on the results of operations for the
three-month or nine-month periods ending September 30, 2003.
In May 2003, the FASB's Emerging Issues Task Force defined the scope of Issue
00-21, "Revenue Arrangements With Multiple Deliverables" ("EITF No. 00-21") and
its interaction with other authoritative literature. This statement is
applicable to agreements entered into for reporting periods beginning after June
15, 2003 and requires companies with revenue arrangements including multiple
deliverables to be divided into separate units of accounting for revenue
recognition purposes, if the deliverables in the arrangement meet certain
criteria, including standalone value to the customer, objective and reliable
evidence of the fair value of the undelivered items exists and if the
arrangement includes a general right of return relative to the delivered item,
delivery or performance of the undelivered item is considered probable and
substantially in the control of the vendor. The adoption of this Statement did
not have a significant effect on the Company's financial position as of
September 30, 2003 or on the results of operations for the three-month or
nine-month periods ending September 30, 2003.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
In 2001, the Company completed a total debt restructuring (see Note 3 for
further information), however, the Company remains highly leveraged and could be
adversely affected by a significant increase in interest rates or a failure to
extend or replace its existing debt agreements prior to December 31, 2004. A one
percent increase in the prime rate would increase the annual interest cost on
the outstanding loan balance at September 30, 2003 of approximately $10.6
million by $.1 million. The Company has minimal foreign currency translation
risk. All international sales other than sales originating from the UK and
Canadian subsidiaries are denominated in United States dollars. Refer to the
Outlook section of Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations.
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Item 4. Controls and Procedures.
The Company evaluated the design and operation of its disclosure controls and
procedures to determine whether they are effective in ensuring that the
disclosure of required information is timely made in accordance with the
Securities Exchange Act of 1934 (the "Exchange Act") and the rules and forms of
the Securities and Exchange Commission. This evaluation was made under the
supervision and with the participation of management, including the Company's
principal executive officer and principal financial officer as of the end of the
period covered by this Quarterly Report on Form 10-Q. The principal executive
officer and principal financial officer have concluded, based on their review,
that the Company's disclosure controls and procedures, as defined at Exchange
Act Rules 13a-14(c) and 15d-14(c), are effective to provide reasonable assurance
that information required to be disclosed by the Company in reports that it
files or submits under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in Securities and Exchange Commission
rules and forms. There were no changes in the Company's internal control over
financial reporting that occurred during the Company's most recent fiscal
quarter that materially affected, or are reasonably likely to materially affect,
the Company's internal control over financial reporting.
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PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits.
Exhibit Number Description
Exhibit 31.1* CEO Certification Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
Exhibit 31.2* CFO Certification Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
Exhibit 32.1* CEO Certification Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
Exhibit 32.2* CFO Certification Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
* Filed herewith.
(b) Reports on Form 8-K.
Report on Form 8-K filed August 1, 2003 regarding second quarter of 2003
earnings.
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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.
SCAN-OPTICS, INC.
Date November 14, 2003 / s/ James C. Mavel
----------------- ------------------------------
James C. Mavel
Chairman, Chief Executive Officer
and President
Date November 14, 2003 / s/ Michael J. Villano
----------------- ------------------------------
Michael J. Villano
Chief Operating Officer,
Chief Financial Officer,
Vice President and Treasurer
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