FORM 10-QSB SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended August 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission file number 01-10076 APPLIED RESEARCH CORPORATION ---------------------------------------------- (Exact name of small business issuer as specified in its charter) Colorado 86-0585693 - --------------------------------- ----------------------- (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification Number) 8201 Corporate Drive, Suite 1110, Landover, Maryland 20785 --------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (301) 459-3773 --------------------------------------------------- (Registrant's telephone number, including area code) ---------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 October 15, 1998, the Company had 6,311,083 shares of its $.01 par value common stock outstanding. Transitional Small Business Disclosure Format (check one): Yes [ ] No [X] FORM 10-QSB APPLIED RESEARCH CORPORATION INDEX ----- Part I: FINANCIAL INFORMATION Page No. - ------- --------------------- ------- Item 1 Financial Statements Condensed Consolidated Balance Sheets - August 31, 1998 (unaudited) and May 31, 1998 3-4 Condensed Consolidated Statements of Operations - Three months ended August 31, 1998 and 1997 (unaudited) 5 Condensed Csolidated Statements of Cash Flows - Three months ended August 31, 1998 and 1997 (unaudited) 6-7 Notes to Condensed Consolidated Financial Statements 8 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 9 Part II: OTHER INFORMATION - -------- ----------------- Item 1 Legal Proceedings 10 Item 2 Changes in Securities 10 Item 3 Defaults Upon Senior Securities 10 Item 4 Submission of Matters to a Vote of Security Holders 10 Item 5 Other Information 10 Item 6 Exhibits and Reports on Form 8-K 10 Signatures 11 APPLIED RESEARCH CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS August 31, May 31, 1998 1998 (Unaudited) (Audited) ------------- ------------- ASSETS - ------ CURRENT ASSETS Cash $ 31,454 $ 46,965 Accounts receivable, net 163,974 163,477 Due from Space Applications Corporation, short-term 251,033 34,900 Other current assets 16,471 14,774 ------------- ------------- TOTAL CURRENT ASSETS 462,932 260,116 ------------- ------------- PROPERTY AND EQUIPMENT, AT COST Furniture and equipment 20,728 20,728 Computer equipment 136,458 136,458 Leasehold improvements 200 200 ------------- ------------- 157,386 157,386 Less accumulated depreciation and amortization 137,286 131,892 ------------- ------------- NET PROPERTY AND EQUIPMENT 20,100 25,494 ------------- ------------- OTHER ASSETS Due from Space Applications Corporation, long-term - 287,500 ------------- ------------- TOTAL ASSETS $ 483,032 $ 573,110 ============= ============= See accompanying notes to the condensed consolidated financial statements. APPLIED RESEARCH CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS - Continued August 31, May 31, 1998 1998 (Unaudited) (Audited) ------------- ------------- LIABILITIES - ----------- CURRENT LIABILITIES Liabilities not subject to compromise: Notes payable, current maturities $ 540 $ 2,120 Loans payable to officers and directors 43,368 44,810 Accounts payable 289,465 263,995 Accrued salaries and benefits 39,434 39,434 Accrued payroll taxes and withholdings 18,807 6,874 Other accrued liabilities 53,338 62,125 Deferred revenue 54,895 64,267 ------------- ------------- Total liabilities not subject to compromise 499,847 483,625 ------------- ------------- Liabilities subject to compromise: Accounts payable - 272,338 Accrued salaries and benefits 198,003 382,781 Accrued payroll taxes and withholdings 150,000 166,039 Accrued interest and penalties 34,338 395,563 ------------- ------------- Total liabilities subject to compromise 382,341 1,216,721 ------------- ------------- TOTAL CURRENT LIABILITIES 882,188 1,700,346 ------------- ------------- STOCKHOLDERS' DEFICIT - --------------------- Preferred stock, $.10 par value, 40,000,000 shares authorized, none issued - - Common stock, $.0005 par value, 60,000,000 shares authorized, 6,811,083 shares issued and 6,311,083 shares outstanding 3,155 3,155 Capital in excess of par value 1,140,529 1,140,529 Accumulated deficit (1,542,840) (2,270,920) ------------- ------------- TOTAL STOCKHOLDERS' DEFICIT (399,156) (1,127,236) ------------- ------------- TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT $ 483,032 $ 573,110 ============= ============= See accompanying notes to the condensed consolidated financial statements APPLIED RESEARCH CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS THREE MONTHS ENDED AUGUST 21, 1998 AND 1997 ------------------------------------------- 1998 1997 (Unaudited) (Unaudited) ------------- ------------- Revenue $ 97,314 $ 132,583 ------------- ------------- Operating costs and expenses: Direct cost of services 58,135 61,827 General & administrative expenses 73,739 86,280 ------------- ------------- Total operating costs and expenses 131,874 148,107 ------------- ------------- Operating loss from continuing operations (34,560) (15,524) ------------- ------------- Other (income) expense: Interest expense, net 370 374 Other, net (2) 3,121 ------------- ------------- Total other (income) expense 368 3,495 ------------- ------------- Loss from continuing operations before income taxes (benefit) (34,928) (19,019) ------------- ------------- Income taxes (benefit) (294,700) (537,600) ------------- ------------- Income from continuing operations 259,772 518,581 ------------- ------------- Income (loss) from discontinued operations before reorganization items, net of income tax (tax benefit) of $(37,700) in 1997 3,806 (32,024) Reorganization items: Professional fees (3,811) (27,805) Income (loss) from the sale of discontinued operations, net of income tax (benefit) of $(14,100) in 1998 and $575,300 in 1997 (22,367) 914,306 ------------- ------------- Income (loss) from discontinued operations (22,372) 854,477 ------------- ------------- Net Income before extraordinary item 237,400 1,373,058 ------------- ------------- Extraordinary item, net of income taxes of $308,800 490,680 - ------------- ------------- Net Income $ 728,080 $ 1,373,058 ============= ============= Net income per common share: Income before discontinued operations $ 0.04 $ 0.08 Income (loss) from discontinued operations - 0.14 ------------- ------------- Income before extraordinary items 0.04 0.22 ------------- ------------- Income from extraordinary item 0.08 - ------------- ------------- Net income per common share $ 0.12 $ 0.22 ============= ============= Weighted average number of shares outstanding 6,311,083 6,311,083 ============= ============= See accompanying notes to the condensed consolidated financial statements APPLIED RESEARCH CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS THREE MONTHS ENDED AUGUST 31, 1998 AND 1997 ------------------------------------------- 1998 1997 (Unaudited) (Unaudited) ------------- ------------- Cash flows from operating activities: Cash received from customers $ 87,444 $ 1,127,709 Cash paid to suppliers and employees (95,850) (1,663,274) Interest paid (272) (16,503) Income taxes paid - (900) ------------- ------------- Net cash used by operating activities before reorganization items (8,678) (552,968) ------------- ------------- Operating cash flows from reorganization items: Professional fees paid for services rendered in connection with the Chapter 11 proceeding (3,811) (27,805) ------------- ------------- Net cash used by reorganization items (3,811) (27,805) ------------- ------------- Net cash used by operating activities (12,489) (580,773) ------------- ------------- Cash flows from investing activities: Proceeds received from the sale of discontinued operations - 1,172,400 Capital expenditures - (2,807) ------------- ------------- Net cash provided from investing activities - 1,169,593 ------------- ------------- Cash flows from financing activities: Advances from (repayments to) loans from officers and directors (1,442) 7,500 Proceeds of loans from receivables assignment - not subject to compromise - 308,336 Repayment of loans from receivables assignment - not subject to compromise - (812,379) Repayment of equipment loan - not subject to compromise (1,580) (1,451) ------------- ------------- Net cash used in financing activities (3,022) (497,994) ------------- ------------- Net (decrease) increase in cash (15,511) 90,826 Cash at the beginning of period 46,965 228,414 ------------- ------------- Cash at the end of period $ 31,454 $ 319,240 ============= ============= See accompanying notes to the condensed consolidated financial statements APPLIED RESEARCH CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS - Continued THREE MONTHS ENDED AUGUST 31, 1998 AND 1997 -------------------------------------------- 1998 1997 (Unaudited) (Unaudited) ------------- ------------- Reconciliation of net income to net cash provided from (used by) operating activities: Net income $ 728,080 $ 1,373,058 Adjustments to reconcile net income to net cash provided rom (used by) operating activities: Depreciation 5,394 10,206 Amortization - 1,332 Gain (loss) from the sale of discontinued operations 22,367 (914,306) Income (tax) benefit generated by gain on the sale of discontinued operations 14,100 (575,300) Extraordinary item (490,680) - Income tax benefit generated by extraordinary item (308,800) - Changes in assets and liabilities: Decrease (increase) in accounts receivable (497) 714,442 Decrease in inventory - 2,324 Increase in other current assets (254,297) (14,669) Decrease in other assets 287,500 7,359 Decrease in accounts payable - subject to compromise - (50,000) Increase in accounts payable - not subject to compromise 25,470 30,368 Decrease in accrued salaries and benefits - subject to compromise (34,900) (182,581) Decrease in accrued salaries and benefits - not subject to compromise - (195,831) Decrease in accrued payroll taxes and withholdings - subject to compromise - (559,367) Increase (decrease) in accrued payroll taxes and withholdings - not subject to compromise 11,933 (101,351) Decrease in other accrued liabilities - not subject to compromise (8,787) (75,916) Increase (decrease) in accrued interest and penalties - subject to compromise - (49,641) Decrease in deferred revenue (9,372) - Decrease in income taxes payable - (900) ------------- ------------- Net cash used by operating activities $ (12,489) $ (580,773) ============= ============= See accompanying notes to the condensed consolidated financial statements APPLIED RESEARCH CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. BASIS OF PRESENTATION --------------------- The Condensed Consolidated Balance Sheet as of August 31, 1998, the Condensed Consolidated Statements of Operations for the three months ended August 31, 1998 and 1997, and the Consolidated Statements of Cash Flows for the three months ended August 31, 1998 and 1997, have been prepared by the Company and are unaudited. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows at August 31, 1998, and for all periods presented, have been made. The Company owns 95% of ARInternet which was formed during November, 1994. However, because the minority interest in net losses of ARInternet exceeded the carrying value of the minority interest amount at August 31, 1998, no minority interest has been reflected in the Condensed Consolidated Financial Statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted. It is suggested that these Condensed Consolidated Financial Statements be read in conjunction with the Financial Statements and Notes thereto included in the Company's Annual Report on Form 10-KSB for the fiscal year ended May 31, 1998. The results of operations for the period ended August 31, 1998, are not necessarily indicative of the operating results for the full year. 2. INCOME (LOSS) PER COMMON SHARE ------------------------------ In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 128, "Earnings per Share" (SFAS no. 128). This statement established standards for computing and presenting earnings per share. In accordance with this statement, basic net income (loss) per share of common stock has been computed based on the weighted average number of shares of common stock outstanding for the period. Diluted net income per share of common stock is computed on the weighted average number of shares of common stock and common stock equivalents outstanding for the year. Diluted net income (loss) per share has not been shown in 1998 and 1997 as the stock options would be anti-dilutive. 3. RECLASSIFICATIONS ----------------- Certain amounts in the Condensed Consolidated Balance Sheet as of May 31, 1998, the Condensed Consolidated Statements of Operations for the three months period ended August 31, 1997, and the Condensed Consolidated Statements of Cash Flows for the three months then ended have been reclassified to conform to the August 31, 1998, presentation. 4. VOLUNTARY PETITION FOR RELIEF UNDER CHAPTER 11/SALE OF ARM'S ASSETS AND MANAGEMENT'S PLANS TO CONTINUE AS A GOING CONCERN ------------------------------------------------------------------- On April 2, 1996, ARM filed a petition for relief under Chapter 11 of the federal bankruptcy laws in the United States Bankruptcy Court for the Southern District of Maryland. Neither ARC, ARS nor ARInternet filed for relief. Under Chapter 11, certain claims against ARM in existence prior to the filing of the petition for relief under the federal bankruptcy laws were stayed while ARM continued business operations as Debtor-In-Possession. These claims are reflected in the information provided in Note 6 under "liabilities subject to compromise". Claims secured against the ARM's assets ("secured claims") also were stayed, although the holders of such claims had the right to move the court for relief from the stay. Secured claims were secured primarily by liens on ARM's property, including ARM's accounts receivable. On April 5, 1996, ARM received an emergency hearing with the Bankruptcy Court to determine its request to pay its employees their pre-petition wages as well as continue to operate the business. Prior to the emergency hearing, ARM reached an agreement with the IRS and its principle lender, CFC, to allow the company to continue to operate and borrow money from CFC against its billed receivables. Under this agreement, ARM agreed to pay $15,000 a month starting April 1996, towards its arrearage with the IRS. The April payment consisted of $13,600 of cash seized by the IRS on April 1, 1996. Subsequent monthly payments continued to be made directly to the IRS by CFC from borrowings made by ARM. ARM was also required to remit to the IRS collections on certain billed receivables that were outstanding as of April 2, 1996 (the final vouchers on 14 old contracts, which totaled approximately $136,700). In addition, as part of the agreement with the IRS and as required by the Bankruptcy Court, ARM was required to remit its post-petition taxes when due and provide proof of such payments to the IRS and the Court on a timely basis. The Bankruptcy Court approved the agreements with the IRS and CFC, and approved ARM's operating budget for 15 days through April 21, 1996. Thereafter, these agreements continued to be renewed by the Bankruptcy Court. While ARM was in bankruptcy, it curtailed accruing interest on all pre- petition obligations except the amounts owed CFC, the secured lender approved by the Bankruptcy Court. SALE OF ARM'S GOVERNMENT CONTRACTS. - ----------------------------------- On March 3, 1997, the Company accepted a contract for the sale of certain of ARM's assets for $1.475 Million from Space Applications Corporation ("SAC"). The sale was subject to Bankruptcy Court approval, which was scheduled for April 11, 1997. At the hearing, a total of three qualified bidders attended, and after extensive bidding, an offer was accepted for $1.75 Million from SAC. The purchase price was payable as follows: $1,172,400 of cash at closing, $322,400 payable over three years and the assumption of liabilities totaling $255,200. Because of the change in the purchase price as well as in the distribution of funds, the original SAC contract required modifications. An amendment to the contract reflecting these changes was signed on April 16, 1997. A Bankruptcy Court order documenting the bidding procedure was approved by the Bankruptcy Court on May 30, 1997. The sale was subject to the successful novation of ARM's Government contracts. This request was approved on June 19, 1997, at which time the sale was completed with payment of the cash portion of the purchase price being placed in escrow. The cash placed in escrow was subsequently disbursed to creditors. A list of the purchased and excluded assets is on the following page: Purchased Assets Excluded Assets ---------------- --------------- - - All Contracts rights - ARM's charter and status as a (including project contracts), corporation, its minute book, stock - - All inventory, transfer records, and similar records - - All books and records, relating to ARM's organization, - - All furniture, fixtures and existence or capitalization, and the equipment, capital stock of ARM, - - All proprietary rights - Billed accounts receivable as of (patents, etc.), closing, - - All unbilled accounts - Intercompany receivables, receivable relating to - All of ARM's cash accounts, expired contracts as of - ARM's rights to occupy real property January 31, 1997, pursuant to leases of real property an - - All other unbilled accounts and any leasehold improvements made receivable as of the closing thereto, date - Any other property identified by the Purchaser prior to the closing. PLAN OF REORGANIZATION/PAYMENT AND PRE-PETITION LIABILITIES. - ----------------------------------------------------------- After the sale was completed, ARM filed a Plan of Reorganization, which, among other things, specified how much of the outstanding pre-petition liabilities would be paid and over what period of time. On July 30, 1998, the Plan was approved by the Bankruptcy Court. Between the monies generated from the sale of ARM's contracts rights plus the collection of outstanding accounts receivable (which were not part of the sale), there was not sufficient monies to liquidate all of ARM's pre-petition liabilities. The condensed consolidated balance sheet at August 31, 1998, have been adjusted to reflect the amount that is currently expected to be paid as part of the approved Plan of Reorganization. Should ARM continue to incur additional professional fees over the amounts currently accrued, by agreement, the additional professional fees will decrease the amounts to be paid to the state tax creditors. See note 6 for additional information. COLLECTION OF THE INTER-COMPANY AMOUNTS OWED TO ARM. - --------------------------------------------------- As of April 2, 1996, ARS owed ARM approximately $1.2 Million and ARInternet owed ARM $0.4 Million. These amounts resulted from ARM paying certain operating expenses of ARS and ARInternet during their start-up phases and providing continued money thereafter to fund operations. Since these amounts are owed to ARM, the ultimate collection of these advances was controlled by the Bankruptcy Court. As part of the approved Plan of Reorganization, ARInternet agreed to pay as settlement for the inter-company amounts owed to the Debtor: 1) $150,000 over three years, 2) half of any net surplus in cash flow derived from ARS or ARInternet operations after debt service, and 3) half of the net profit from any future sale of ARInternet. This settlement is secured by a lien on all assets of ARS and ARInternet, and was personally guaranteed by the President of ARC. IMPACT ON ARC AFTER THE SALE OF ARM'S ASSETS WAS COMPLETED. - ---------------------------------------------------------- During the fiscal year ended May 31, 1998, ARM's operations constituted 37% of ARC's total revenue. The sale transferred essentially all of ARM's assets and operations to the Purchaser and eliminated all of ARM's revenues. Therefore, ARS and ARInternet are the only remaining operating entities. Up until the bankruptcy filing, ARM had been forced to continue to fund ARS's and ARInternet's operations. During the fiscal year ended May 31, 1996, (through April 2, 1996), ARM funded approximately $204,600 of ARS and ARInternet expenses. After April 2, 1996, because of the ARM bankruptcy proceedings, ARM ceased all such advances and ARS and ARInternet were forced to fund their own operations. ARS is still not operating at cash flow breakeven, so it is doubtful that it can survive without a substantial infusion of cash or a significant increase in revenues. Management is considering several options for ARS, including ceasing its operations. ARInternet on the other hand, as of May 31, 1998, had approximately 750 subscribers and had essentially reached breakeven operations. Management believes that ARInternet's revenues and business will continue to grow and that ARInternet will ultimately be a successful business on its own, however there can be no assurance of this. The sale of ARM's assets dramatically changed the Company's balance sheet and statement of operations. Through the bankruptcy proceeding, all of ARM's debts, which totaled approximately $1.4 million at July 30, 1998, will be either liquidated or discharged (See Note 6). If ARS and ARInternet's revenues can be increased to produce net profits and a positive cash flow, the Company may in fact benefit from the sale of ARM's assets. However, unless and until this occurs, the Company may not have sufficient capital to achieve its current business plan, which raises substantial doubt as to the Company's ability to continue as a going concern after the sale of ARM's assets. 5. DISCONTINUED OPERATIONS ----------------------- On June 19, 1997, the Company consummated the sale of substantially all of the assets of ARM to SAC (the "Sale"). Accordingly, results from operations for ARM have been shown as discontinued operations for the three months ended August 31, 1998 and 1997. A reconciliation of the sales price to the net cash received is presented below: Sales price $ 1,750,000 Less: Payments due over a period of one to three years (322,400) Less: Assumption of vacation liability (255,200) ------------- Net cash received at closing $ 1,172,400 ============= Distribution of the cash received at closing was as follows: Internal Revenue Service - pre-petition taxes $ 609,000 Employees - pre-petition 401(k) contributions 271,017 Employees - pre-petition expenses 50,000 Administrative expenses associated with sale of ARM 60,000 Cash held in Escrow for administrative claims 182,383 ------------- Net cash received at closing $ 1,172,400 ============= Of the deferred amounts referenced above, $34,900 was due and paid during June 1998. The remainder of $287,500 was due in two installments, $162,500 in June 1999 and $125,000 in June 2000. ARM reached agreement with all of the creditors involved to accept a discounted current payment in lieu of the scheduled payments. The amount shown in the August 31, 1998 condensed consolidated balance sheet as Due from Space Applications Corporation was paid into escrow during August 1998. During September 1998, ARM received Bankruptcy Court approval and this money is expected to be remitted to the various creditors during October 1998. A summary of ARM's results from operations for the three months ended August 31, 1998 and 1997 are shown below: THREE MONTHS ENDED AUGUST 31, 1998 AND 1997 - ------------------------------------------- 1998 1997 (Unaudited) (Unaudited) ------------- ------------- Revenue $ - $ 280,683 ------------- ------------- Operating costs and expenses: Direct cost of services - 174,190 Indirect operating costs - 74,224 General & administrative expenses 128 108,793 ------------- ------------- Total operating costs and expenses 128 355,207 ------------- ------------- Operating loss from discontinued operations (128) (74,524) ------------- ------------- Other (income) expense: Interest expense, net (99) 14,490 Other, net (3,835) (19,290) ------------- ------------- Total other expense (3,934) (4,800) ------------- ------------- Income tax (tax benefit) - (37,700) ------------- ------------- Income (loss) from discontinued operations before reorganization items 3,806 (32,024) Reorganization items - professional fees (3,811) (27,085) ------------- ------------- Loss from discontinued operations $ (5) $ (59,829) ============= ============= 6. EXTRAORDINARY ITEM ------------------ On July 30, 1998, the Bankruptcy Court confirmed ARM's plan of reorganization. The confirmed plan resulted in the following adjustments to ARM's August 31, 1998 Balance Sheet: August 31, 1998 August 31, 1998 Balance Sheet Balance Sheet Before After Adjustment Adjustment for Approved for Approved Plan of Plan of Reorganization Reorganization Difference --------------- --------------- ------------ ASSETS - ------ CURRENT ASSETS Cash $ 28,678 $ 28,678 $ - Accounts receivable from customers, net 127,010 127,010 - Intercompany advances receivable 1,601,205 150,000 (1,451,205) Due from Space Application Corporation, short-term 251,033 251,033 - Other current assets 12,184 12,184 - -------------- -------------- ------------- TOTAL CURRENT ASSETS 2,020,110 589,906 (1,451,205) -------------- -------------- ------------- TOTAL ASSETS $ 2,020,110 $ 589,906 $(1,451,205) ============== ============== ============= LIABILITIES - ----------- CURRENT LIABILITIES Liabilities not subject to compromise: Accounts payable $ 134,812 $ 134,812 $ - Other accrued liabilities 51,753 51,753 - -------------- -------------- ------------- Total liabilities not subject to compromise 186,565 186,565 - -------------- -------------- ------------- Liabilities subject to compromise: Accounts payable 272,338 - (272,338) Accrued salaries and benefits 347,882 198,003 (149,879) Accrued payroll taxes and withholdings 166,039 150,000 (16,039) Accrued interest and penalties 395,562 34,338 (361,224) -------------- -------------- ------------- Total liabilities subject to compromise 1,181,821 382,341 (799,480) -------------- -------------- ------------- TOTAL CURRENT LIABILITIES 1,368,386 568,906 (799,480) -------------- -------------- ------------- STOCKHOLDERS' EQUITY - -------------------- Investment by ARC 1,029,621 1,029,621 - Accumulated Deficit (377,897) (1,029,621) (651,724) -------------- -------------- ------------- TOTAL STOCKHOLDERS' EQUITY 651,724 - (651,724) -------------- -------------- ------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 2,020,110 $ 589,906 $(1,451,205) ============== ============== ============= The company accounted for the reorganization as a troubled debt restructuring whereby, the gain on the restructuring of the pre-petition liabilities of $799,480 was aggregated and treated as an extraordinary item in the accompanying condensed consolidated statement of operations. The extraordinary item has been shown net of the income tax expense of $308,800. Inter company receivables are eliminated in consolidation and therefore these adjustments did not impact the consolidated statement of operations. However, these write downs did impact ARM's, ARS' and ARInternet's individual balance sheets and their individual statement of operations. This will also have income tax consideration in the states where these companies do not file consolidated tax returns. However, it is expected that these companies will have sufficient net operating losses to offset any potential income generated by this transaction. 7. SUPPLEMENTAL SEGMENT INFORMATION -------------------------------- The Company's continuing operations have been classified into two business segments: ARS ARInternet Consolidated ------------ ------------ ------------ Sales to unaffiliated customers: Quarter ended: -------------- August 31, 1998 $ 19,955 $ 77,359 $ 97,314 August 31, 1997 $ 36,542 $ 96,041 $ 132,583 Operating loss from continuing operations before other (income) expense and income taxes: Quarter ended: -------------- August 31, 1998 $ (1,698) $ (31,862) $ (33,560) August 31, 1997 $ (1,243) $ (14,281) $ (15,524) Operating loss equals total net revenues less operating expenses. ARM's results have been reported as discontinued operations in the accompanying condensed consolidated financial statements, since the Company sold substantially all of the operating assets of ARM (see Note 5). MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS FROM OPERATIONS Overview - -------- Applied Research Corporation ("the Company") is comprised of two wholly owned subsidiaries, Applied Research of Maryland, Inc. ("ARM") and ARSoftware Corporation ("ARS"), and a majority owned subsidiary, ARInternet Corporation ("ARInternet"). ARM currently consists of three unincorporated divisions: Technical Services Division, Instruments Division and ARInstruments Division ("ARInstruments"). Management's Discussion and Analysis of Financial Condition and Results of Operations takes into consideration the activities of the Company as a whole and each individual operating entity where necessary. Management's Discussion and Analysis should be read in conjunction with the Company's Condensed Consolidated Financial Statements, including the footnotes thereto. Results from Operations - Three Months Ended August 31, 1998 Compared to 1997 - ------------------------------------------------------------------------- FROM CONTINUING OPERATIONS The Company's revenues for the quarter ended August 31, 1998, were $97,314, or 27% below revenues of $132,583 for the same period during 1997. The decrease of $(35,269) in revenues during the quarter ended August 31, 1998, is attributable to the decrease in ARInternet's revenues of $(18,682) or (19%), and the decrease in ARS' revenues of $(16,587) or (45)% over the same period in 1997. The decrease in ARInternet's revenue were caused by a reduction in the number of subscribers serviced by the company, which the company beliefs is primarily related to the company not offering digital access capability. Subsequent to August 31, 1997, ARInternet contracted to upgrade its services for digital access capability. The decrease in ARS' revenues related to a decrease in the amount of products sold. The Company's direct cost of services decreased $(3,692) or (6)%, from $61,827 during the quarter ended August 31, 1997, to $58,135 during the same period in 1998. Of this amount, ARInternet increased $10,214 or 30%, while ARS' cost of services decreased $(13,906) or (49%). The increase in direct costs of ARInternet related to the increase in the basic connectivity services, while the decrease of ARS' direct costs related to the decrease in sales for the quarter compared to the same period in 1997. General and administrative ("G&A") expenses decreased $(12,541) or (15)%, from $86,280 in 1997, to $73,739 during 1998. Most notably, the G&A expenses associated with ARInternet decreased $(11,314), or (15)% due to a reduction in the amount of salaries. ARS' G&A expenses decreased $(1,227) or (13%), which was attributed to the reduction in personnel costs. The decrease in ARInternet's G&A expenses related to a reduction in staffing during 1997 when compared to the same period in 1998. As a result of the foregoing, the Company realized a operating loss from continuing operations for the quarter ended August 31, 1998, of $(34,560) compared to a operating loss of $(15,524) for the same period during 1997. ARS realized a operating loss of $(1,698) for the quarter ended August 31, 1998, which loss represented a regression of $(455) or (37)% from the operating loss of $(1,243) during the same period in 1997. ARInternet realized a operating loss of $(31,862) for the quarter ended August 31, 1998, which represented a regression of $(17,581) from the operating loss of $(14,281) during the same period in 1997. Interest and other expenses decreased $(3,127), from $3,495 for the quarter ended August 31, 1997, to $368 during the quarter ended August 31, 1998. The increase was primarily related to a decrease in the amount of penalties that are being incurred. The Company realized a loss from continuing operations before income taxes of $(34,928) for the quarter ended August 31, 1998, compared to a loss from continuing operations of $(19,019) during the same period in 1997. This change in results from continuing operations was primarily caused by the decrease in ARInternet's operating income. The Company realized income from continuing operations of $518,581 during 1997 and $259,772 during 1998, after the realization of the income tax benefit associated with the gain in the sale of ARM of $537,600 during 1997, and the tax benefit associated with the extraordinary item of $294,700 during 1998. Based on the foregoing, income (loss) per common share from continuing operations changed from $0.08 in 1997 to $0.04 in 1998. FROM DISCONTINUED OPERATIONS ARM's revenues for the quarter ended August 31, 1998, were $0, or (100)% below revenues of $280,683 for the same period during 1997. The decrease in revenues during the quarter ended August 31, 1998, is attributable to the sale of ARM which was effective June 19, 1997. Effective with the sale of ARM, all of ARM's direct employees terminated their employment relationships with ARM and, as a result, all revenues of ARM ceased. ARM's direct cost of services decreased $174,190 or 100%, from $174,190 during the quarter ended August 31, 1997, to $0 during the same period in 1998. ARM's decrease in direct costs was due to the decrease in direct labor due, which, in turn, was due to the sale of ARM. ARM's indirect operating costs decreased $74,224 or 100%, from $74,224 during the quarter ended August 31, 1997, to $0 during the quarter ended August 31, 1998. This decrease is directly related to a decrease in direct labor costs incurred. ARM's general and administrative ("G&A") expenses decreased $108,665 or 100%, from $108,793 in 1997, to $128 during 1998. The decrease in ARM's G&A expenses was directly attributable to the sale of ARM. ARM may, however, continue to incur some minor G&A expenses while winding down ARM's affairs in the Bankruptcy Court, which is expected to take a few months. As a result of the foregoing, ARM realized an operating loss for the quarter ended August 31, 1998, of $(74,524) compared to an operating loss of $(128) for the same period during 1997. The $74,396 decrease in ARM's 1998 operating margin was primarily related to the sale of ARM's contracts and the discontinuation of ARM's operations. ARM's interest and other expenses increased $866, from $(4,800) for the quarter ended August 31, 1997, to $(3,934) during the quarter ended August 31, 1998. Net interest expense decreased $14,589 or 101% from 1997. The decrease in interest costs was the result of ARM paying off its secured debt during July 1997. Other expenses increased $15,456 or 80% during the quarter ended August 31, 1998. The amounts shown under other expenses represent collections on receivables that had been written off in previous years. During 1998, ARM reported a gain before the gain (loss) on the sale of ARM of $3,806 for the quarter ended August 31, 1998, compared to a loss of $(32,024) during the same period last year. Liquidity and Capital Resources - 1998 Compared to 1997 - ------------------------------------------------------- Total assets decreased $90,078 or 16%, from $573,110 at May 31, 1998, to $483,032 at August 31, 1998. Total liabilities on the other hand decreased from $1,700,346 to $882,188 over the same period, or a decrease of $818,158, or 48%. The most significant reason for the decrease in total assets was the decrease in the amount due from Space Applications Corporation. During June 1998, Space Application Corporation paid $34,900, the installment due from the June 1997 sale. Additionally, during the quarter ended August 31, 1998, the Company extended Space Applications Corporation a discount of $36,467 for a current payment of $251,033 on the remaining installment payments of $287,500. All of the creditors agreed to the discounted payment. The most significant reasons for the $16,222 increase in post-petition liabilities collectively, were increases in: accounts payable increased by $25,470 as well as accrued payroll taxes and withholdings by $11,933, offset by decreases in notes payable of $1,580, loans payable to officers and directors of $1,442, other accrued liabilities of $8,787 and deferred revenue of $9,372. The majority of the post-petition accounts payable consisted of unpaid professional fees related to the bankruptcy proceeding, which must be court approved by the Bankruptcy Court before they can be paid. The decrease in pre-petition liabilities of $(834,380) resulted receipt of the installment payment of $34,900 from Space Applications Corporation as well as the write off of $799,480 resulting from the discharge of these liabilities upon the approval of the Plan of Reorganization by the Bankruptcy Court on July 30, 1998. The Company's working capital deficit improved $1,020,974 or 71% during the quarter ended August 31, 1998, from a deficit of $(1,440,230) at May 31, 1998 to a deficit of $(419,256) at August 31, 1998. This was primarily the result of the discharge of $799,480 pre-petition liabilities as a result of the approval of the plan of reorganization. FILING OF CHAPTER 11 PETITION BY ARM The following is a chronology of the events leading up to ARM filing for protection under Chapter 11 of the United States Bankruptcy laws on April 2, 1996, as well as a discussion of what has happened since the filing and subsequent signing of an agreement to sell the majority of ARM's assets to SAC. Because ARM was in default under its December 1, 1995, installment agreement with the IRS, the Company's assets were subject to immediate seizure and possible sale by the IRS. To that end, on April 1, 1996, the IRS issued Levy Notices to ARM's bank, financing company and the majority of its customers. On April 2, 1996, the IRS attempted to close ARM. As a result, on April 2, 1996, ARM was forced to file for protection under Chapter 11 of the United States Bankruptcy Code. On April 5, 1996, ARM received an emergency hearing with the Bankruptcy Court to determine its request to pay its employees their pre-petition wages as well as continue to operate the business. Prior to the emergency hearing, ARM reached an agreement with the IRS and its principle lender, CFC, to allow the company to continue to operate and borrow money from CFC against its billed receivables. Under this agreement, ARM agreed to pay $15,000 a month starting April 1996, towards its arrearage with the IRS. The April payment consisted of $13,600 of cash seized by the IRS on April 1, 1996. Subsequent monthly payments continued to be made directly to the IRS by CFC from borrowings made by ARM. ARM was also required to remit to the IRS collections on certain billed receivables that were outstanding as of April 2, 1996 (the final vouchers on 14 old contracts, which totaled approximately $136,700). In addition, as part of the agreement with the IRS and as required by the Bankruptcy Court, ARM was required to remit its post-petition taxes when due and provide proof of such payments to the IRS and the Court on a timely basis. The Bankruptcy Court approved the agreements with the IRS and CFC, and approved ARM's operating budget for 15 days through April 21, 1996. Thereafter, these agreements continued to be renewed by the Bankruptcy Court. While ARM was in bankruptcy, it curtailed accruing interest on all pre- petition obligations except the amounts owed CFC, the secured lender approved by the Bankruptcy Court. SALE OF ARM'S GOVERNMENT CONTRACTS. On March 3, 1997, the Company accepted a contract for the sale of certain of ARM's assets for $1.475 Million from Space Applications Corporation ("SAC"). The sale was subject to Bankruptcy Court approval, which was scheduled for April 11, 1997. At the hearing, a total of three qualified bidders attended, and after extensive bidding, an offer was accepted for $1.75 Million from SAC. The purchase price was payable as follows: $1,172,400 of cash at closing, $322,400 payable over three years and the assumption of liabilities totaling $255,200. Because of the change in the purchase price as well as in the distribution of funds, the original SAC contract required modifications. An amendment to the contract reflecting these changes was signed on April 16, 1997. A Bankruptcy Court order documenting the bidding procedure was approved by the Bankruptcy Court on May 30, 1997. The sale was subject to the successful novation of ARM's Government contracts. This request was approved on June 19, 1997, at which time the sale was completed with payment of the cash portion of the purchase price being placed in escrow. The cash placed in escrow was subsequently disbursed to creditors. A list of the purchased and excluded assets is on the following page: Purchased Assets Excluded Assets ---------------- --------------- - - All Contracts rights - ARM's charter and status as a (including project contracts), corporation, its minute book, stock - - All inventory, transfer records, and similar records - - All books and records, relating to ARM's organization, - - All furniture, fixtures and existence or capitalization, and the equipment, capital stock of ARM, - - All proprietary rights - Billed accounts receivable as of (patents, etc.), closing, - - All unbilled accounts - Intercompany receivables, receivable relating to - All of ARM's cash accounts, expired contracts as of - ARM's rights to occupy real property January 31, 1997, pursuant to leases of real property an - - All other unbilled accounts and any leasehold improvements made receivable as of the closing thereto, date - Any other property identified by the Purchaser prior to the closing. PLAN OF REORGANIZATION/PAYMENT AND PRE-PETITION LIABILITIES. After the sale was completed, ARM filed a Plan of Reorganization, which, among other things, specified how much of the outstanding pre-petition liabilities would be paid and over what period of time. On July 30, 1998, the Plan was approved by the Bankruptcy Court. Between the monies generated from the sale of ARM's contracts rights plus the collection of outstanding accounts receivable (which were not part of the sale), there was not sufficient monies to liquidate all of ARM's pre-petition liabilities. The condensed consolidated balance sheet at August 31, 1998, have been adjusted to reflect the amount that is currently expected to be paid as part of the approved Plan of Reorganization. Should ARM continue to incur additional professional fees over the amounts currently accrued, by agreement, the additional professional fees will decrease the amounts to be paid to the state tax creditors. See note 6 for additional information. COLLECTION OF THE INTER-COMPANY AMOUNTS OWED TO ARM. As of April 2, 1996, ARS owed ARM approximately $1.2 Million and ARInternet owed ARM $0.4 Million. These amounts resulted from ARM paying certain operating expenses of ARS and ARInternet during their start-up phases and providing continued money thereafter to fund operations. Since these amounts are owed to ARM, the ultimate collection of these advances was controlled by the Bankruptcy Court. As part of the approved Plan of Reorganization, ARInternet agreed to pay as settlement for the inter-company amounts owed to the Debtor: 1) $150,000 over three years, 2) half of any net surplus in cash flow derived from ARS or ARInternet operations after debt service, and 3) half of the net profit from any future sale of ARInternet. This settlement is secured by a lien on all assets of ARS and ARInternet, and was personally guaranteed by the President of ARC. IMPACT ON ARC AFTER THE SALE OF ARM'S ASSETS WAS COMPLETED. During the fiscal year ended May 31, 1998, ARM's operations constituted 37% of ARC's total revenue. The sale transferred essentially all of ARM's assets and operations to the Purchaser and eliminated all of ARM's revenues. Therefore, ARS and ARInternet are the only remaining operating entities. Up until the bankruptcy filing, ARM had been forced to continue to fund ARS's and ARInternet's operations. During the fiscal year ended May 31, 1996, (through April 2, 1996), ARM funded approximately $204,600 of ARS and ARInternet expenses. After April 2, 1996, because of the ARM bankruptcy proceedings, ARM ceased all such advances and ARS and ARInternet were forced to fund their own operations. ARS is still not operating at cash flow breakeven, so it is doubtful that it can survive without a substantial infusion of cash or a significant increase in revenues. Management is considering several options for ARS, including ceasing its operations. ARInternet on the other hand, as of May 31, 1998, had approximately 750 subscribers and had essentially reached breakeven operations. Management believes that ARInternet's revenues and business will continue to grow and that ARInternet will ultimately be a successful business on its own, however there can be no assurance of this. The sale of ARM's assets dramatically changed the Company's balance sheet and statement of operations. Through the bankruptcy proceeding, all of ARM's debts, which totaled approximately $1.4 million at July 30, 1998, will be either liquidated or discharged (See Note 6). If ARS and ARInternet's revenues can be increased to produce net profits and a positive cash flow, the Company may in fact benefit from the sale of ARM's assets. However, unless and until this occurs, the Company may not have sufficient capital to achieve its current business plan, which raises substantial doubt as to the Company's ability to continue as a going concern after the sale of ARM's assets. Inflation - --------- The Company anticipates increases in costs associated with the operation of the business and reflects this in the cost of living escalation factors proposed on all new work. In addition, the Company is continually researching areas to minimize cost increases and strives for improved efficiencies in all aspects of its business environment. PART II - OTHER INFORMATION Item 1: Legal Proceedings ----------------- None Item 2: Changes in Securities --------------------- None Item 3: Defaults Upon Senior Securities ------------------------------- None Item 4: Submission of Matters to a Vote of Security Holders --------------------------------------------------- None Item 5: Other Information ----------------- None Item 6: Exhibits and Reports on Form 8-K -------------------------------- Exhibits: Exhibit 27 - Financial Data Schedule Reports on Form 8-K: None APPLIED RESEARCH CORPORATION AND SUBSIDIARIES 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. /s/ S.P.S. Anand October 21, 1998 - ------------------------------------------ ---------------- Dr. S.P.S. Anand Date President and Chief Executive Officer /s/ Dennis H. O'Brien October 21, 1998 - ------------------------------------------ ---------------- Dennis H. O'Brien Date Vice President and Chief Financial Officer