UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
/ X / QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2001
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 000-27941
NETGATEWAY, INC.
---------------
(Exact name of registrant as specified in its charter)
Delaware 87-0591719
-------- ----------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
754 E. Technology Avenue
Orem, Utah 84097
---------- -----
(Address of Principal Executive Offices) (Zip Code)
(801) 227-000
-------------
(Registrant's telephone number, including area code)
Not Applicable
--------------
(Former name, former address and former fiscal year,
if changed since last report)
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 proceeding 12 months and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
--- ---
The number of shares outstanding of the registrant's common stock as of
September 30, 2001: 42,009,266.
When we refer in this Form 10-Q to "Netgateway," the "Company," "we,"
"our," and "us," we mean Netgateway, Inc., a Delaware corporation, together with
our subsidiaries and their respective predecessors.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
Condensed Consolidated Balance Sheets at September 30, 2001
(unaudited) and at June 30, 2001.....................................3
Unaudited Condensed Consolidated Statements of Operations
for the three months ended September 30, 2001 .......................4
Unaudited Consolidated Statement of Capital Deficit for the three months
ended September 30, 2001.............................................5
Unaudited Consolidated Statements of Cash Flows for the three months
ended September 30, 2001 ............................................6
Notes to Unaudited Condensed Consolidated Financial Statements ................7
NETGATEWAY, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
September 30, 2001 June 30,
(Unaudited) 2001
---------------------- ----------------------
Assets
Current assets
Cash $ 109,728 $ 149,165
Trade receivables, net of allowance for doubtful accounts of $2,152,754
at September 30, 2001 and $1,180,875 at June 30, 2001. 2,515,301 1,189,853
Inventories 29,408 44,726
Prepaid expenses 226,236 115,935
Common stock subscriptions receivable 300,000 107,000
Credit card reserves, net of allowance for doubtful accounts of $122,815
at September 30, 2001 and $173,000 at June 30, 2001. 1,018,784 1,187,502
Other current assets - 3,219
---------------------- ----------------------
Total current assets 4,199,457 2,797,401
Property and equipment, net 651,771 774,862
Intangible assets, net 566,869 588,544
Trade receivables, net of allowance for doubtful accounts of $1,129,276
at September 30, 2001 and $1,011,774 at June 30, 2001. 1,215,840 900,198
Other assets, net of allowance for doubtful accounts of $1,618,110
at September 30, 2001 and $1,390,640 at June 30, 2001. 354,042 993,992
---------------------- ----------------------
Total Assets $ 6,987,979 $ 6,054,997
====================== ======================
Liabilities and Capital Deficit
Current liabilities
Accounts payable $ 1,414,068 $ 2,663,066
Bank overdraft 672,384 666,683
Accrued wages and benefits 856,446 581,400
Past due payroll taxes 449,003 497,617
Accrued liabilities 330,178 567,916
Current portion of capital lease obligations 19,122 37,802
Notes payable current - 97,779
Notes payable - officers and stockholders - 490,000
Loan payable - 100,000
Other current liabilities 447,780 423,578
Current portion of deferred revenue 2,239,947 5,618,849
Convertible debenture - 2,405,062
---------------------- ----------------------
Total current liabilities 6,428,928 14,149,753
Deferred revenue, net of current portion 40,638 414,743
Convertible long term notes 65,366 442,172
Note Payable 400,000 -
---------------------- ----------------------
Total liabilities 6,934,932 15,006,667
---------------------- ----------------------
Commitments and contingencies
Minority interest 355,159 355,159
---------------------- ----------------------
Capital deficit
Capital stock, par value $.001 per share
Preferred stock - authorized 5,000,000 shares; none issued
Common stock - authorized 250,000,000 shares; issued and outstanding
42,009,266 and 24,460,191, at September 30, 2001 and June 30, 2001,
respectively 42,010 24,460
Additional paid-in capital 68,408,361 62,047,292
Subscribed common stock 682,200 398,200
Deferred compensation (45,859) (52,649)
Accumulated other comprehensive loss (4,902) (4,902)
Accumulated deficit (69,383,922) (71,719,230)
---------------------- ----------------------
Total capital deficit (302,112) (9,306,829)
---------------------- ----------------------
Total Liabilities and Capital Deficit $ 6,987,979 $ 6,054,997
====================== ======================
See Notes to Consolidated Financial Statements
NETGATEWAY, INC.
Consolidated Statements of Operation for the
Three Months Ended September 30, 2001 and September 30, 2000
Three Months Ended
---------------------------------------------------
September 30, September 30,
2001 2000
------------------------ -------------------
Revenue $ 11,634,043 $ 7,425,857
Cost of revenue 1,589,569 2,189,907
------------------------ -------------------
Gross profit 10,044,474 5,235,949
------------------------ -------------------
Operating expenses
Product development 53,400 1,214,324
Selling and marketing 3,611,796 6,848,155
General and administrative 2,400,987 2,288,710
Depreciation and amortization 151,628 410,168
------------------------ -------------------
Total operating expenses 6,217,811 10,761,357
------------------------ -------------------
Operating income (loss) before items shown below 3,826,663 (5,525,407)
------------------------ -------------------
Other income (expense):
Other income (expense) 101,773 (7,736)
Interest expense (1,593,128) (945,430)
------------------------ -------------------
Total other expenses (1,491,355) (953,166)
------------------------ -------------------
Income (loss) from continuing operations 2,335,308 (6,478,573)
------------------------ -------------------
Discontinued operations:
Loss from discontinued operations - (201,462)
------------------------ -------------------
Net Income (loss) 2,335,308 (6,680,035)
======================== ===================
Basic earnings (loss) per share:
Income (loss) from continuing operations $ 0.07 $ (0.30)
Loss from discontinued operations - (0.01)
------------------------ -------------------
Net income (loss) $ 0.07 $ (0.31)
======================== ===================
Diluted earnings (loss) per share:
Income (loss) from continuing operations $ 0.07 $ (0.30)
Loss from discontinued operations - (0.01)
------------------------ -------------------
Net income (loss) $ 0.07 $ (0.31)
======================== ===================
Weighted average common shares outstanding
Basic 34,507,113 21,691,464
Diluted 35,397,236 21,691,464
See Notes to Consolidated Financial Statements
NETGATEWAY, INC.
Consolidated Statement of Capital Deficit
Common Stock Additional Common
------------------------------- Paid-in Stock
Shares Amount Capital Subscribed
- ---------------------------------------------------------------------- ------------- ---------------- ----------------
Balance June 30, 2001 24,460,191 $ 24,460 $ 62,047,292 $ 398,200
Stock options exercised 6,910 7 1,720
Amortization of deferred compensation -
Forfeiture of stock options - (180)
Conversion of convertible debenture 2,800,000 2,800 2,113,085
Conversion of long term notes 7,204,326 7,205 1,792,975
Private placement of common stock 6,705,924 6,706 2,005,070
Common stock shares issued for outstanding liabilities 831,915 832 448,400
Private placement offering subscriptions received, net 0 284,000
Net income
------------- ------------- ---------------- ----------------
Balance June 30, 2001 42,009,266 $ 42,010 $ 68,408,361 $ 682,200
============= ============= ================ ================
(CONTINUED ON NEXT PAGE)
See Notes to Consolidated Financial Statements
NETGATEWAY, INC.
Consolidated Statement of Capital Deficit
(Continued From Previous Page)
Accumulated
Other Total
Deferred Accumulated Comprehensive Capital
Compensation Deficit loss Deficit
------------ ----------------- ------------------- ----------------
Balance June 30, 2001 $ (52,649) $ (71,719,230) $ (4,902) $ (9,306,829)
Stock options exercised 1,727
Amortization of deferred compensation 6,610 6,610
Forfeiture of stock options 180 -
Conversion of convertible debenture 2,115,885
Conversion of long term notes 1,800,180
Private placement of common stock 2,011,776
Common stock shares issued for outstanding liabilities 449,232
Private placement offering subscriptions received, net 284,000
Net income 2,335,308 2,335,308
------------- ----------------- ------------------- ----------------
Balance June 30, 2001 $ (45,859) $ (69,383,922) $ (4,902) $ (302,112)
============= ================= =================== ================
See Notes to Consolidated Financial Statements
NETGATEWAY, INC
Consolidated Statements of Cash Flows
-------------------------------------------
Three months ended September 30,
-------------------------------------------
2001 2000
-------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Income (loss) from continuing operations $ 2,335,308 $ (6,478,573)
Adjustments to reconcile net income (loss) to net
cash used in operating activities:
Depreciation and amortization 151,628 410,168
Amortization of deferred compensation 6,610 159,959
Interest expense from beneficial conversion feature 884,000
Common stock issued for services 199,657 7,000
Amortization of debt issue costs 642,019 9,333
Amortization of debt discount 1,482,422 21,583
Changes in assets and liabilities:
Trade receivables and unbilled receivables (1,641,089) (1,600,511)
Inventories 15,318 16,818
Prepaid expenses and other current assets (107,082) (358,063)
Credit card reserves 168,718 -
Other assets (2,069) -
Deferred revenue (3,753,007) 2,969,551
Accounts payable, accrued expenses and other liabilities (834,754) (292,050)
----------------------------------------
Net cash used in continuing operating activities (1,336,320) (4,250,785)
Net cash used in discontinued operations - (219,214)
----------------------------------------
Net cash used in operating activities (1,336,320) (4,469,999)
----------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Acquisition of equipment (6,862) 91,442
----------------------------------------
Net cash provided by (used in) investing activities (6,862) 91,442
----------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of common stock 1,421,776 -
Proceeds for common stock subscribed 91,000 -
Proceeds from exercise of options and warrants 1,727 2,250
Bank overdraft borrowing 5,701 249,000
Proceeds from issuance of convertible debenture - 2,500,000
Repayment of convertible debenture (100,000)
Repayment of note payable - bank (97,779)
Repayment of capital lease obligations (18,680) -
Repayment of notes (52,502)
Cash paid for debt issue costs - (270,026)
----------------------------------------
Net cash provided by financing activities 1,303,745 2,428,722
----------------------------------------
NET DECREASE IN CASH (39,437) (1,949,835)
CASH AT THE BEGINNING OF THE PERIOD 149,165 2,606,991
Effect of exchange rate changes on cash balances - (608)
----------------------------------------
CASH AT THE END OF THE PERIOD $ 109,728 $ 656,548
========================================
Supplemental disclosures of non-cash transactions:
Interest Expense from beneficial conversion feature 884,000
Conversion of convertible notes to common stock 1,800,180 -
Conversion of debenture to common stock 2,115,885
Conversion of notes payable - officers and stockholders to common stock 490,000
Conversion of loan payable to common stock 100,000
Value of warrants in connection with the issuance of convertible long term notes - 371,000
Common stock issued for outstanding liabilities 449,234 -
Common stock issued for services - 7,000
Supplemental disclosure of cash flow information:
Cash paid for Interest 1,732 61,012
See Notes to Consolidated Financial Statements
NETGATEWAY, INC. AND SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements
(1) Description of Business
Netgateway, Inc. and subsidiaries ("Netgateway" or the "Company"), was
formed on March 4, 1998 as a Nevada corporation. Netgateway is an e-Services
company that provides eCommerce training, technology, continuing education and a
variety of other web-based resources to small businesses and entrepreneurs
through informational Preview Training Sessions and Internet training workshops.
Through these workshops and follow up telemarketing the Company sells a license
to use its proprietary StoresOnline software and website development platform
and an integrated package of services including hosting of the customer's
website on the Company's Galaxy Mall Internet shopping mall, eCommerce services
and a program of one on one Internet training services.
In January 2001, the Company sold one of its subsidiaries that was
previously reported as a separate segment, and accordingly has reported the
operations as discontinued operations in the accompanying consolidated financial
statements.
The information at September 30, 2001 and for the three months ended
September 30, 2001 and 2000, is unaudited, but includes all adjustments
(consisting only of normal recurring adjustments) which in the opinion of
management, are necessary to state fairly the financial information set forth
therein in accordance with generally accepted accounting principles. The interim
results are not necessarily indicative of results to be expected for the full
fiscal year period. Certain information and footnote disclosures have been
omitted pursuant to rules and regulations published by the Securities and
Exchange Commission ("SEC"), although the Company believes that the disclosures
are adequate to make the information presented not misleading. These financial
statements should be read in conjunction with the audited financial statements
for the year ended June 30, 2001 included in the Company's Annual Report on Form
10-K filed with the SEC.
(2) Summary of Significant Accounting Policies
(a) Principles of Consolidation
The consolidated financial statements include the accounts of the
Company and its wholly owned subsidiaries. All significant intercompany balances
and transactions have been eliminated in consolidation.
(b) Inventories
Inventories are stated at the lower of cost (first-in, first-out) or
market. Inventory consists mainly of products provided in conjunction with the
Internet training workshops.
(c) Property and Equipment
Property and equipment are stated at cost. Depreciation expense is
computed principally on the straight-line method in amounts sufficient to write
off the cost of depreciable assets over their estimated useful lives ranging
from 3 to 5 years. The cost of leasehold improvements is being depreciated using
the straight-line method over the shorter of the estimated useful life of the
asset or the terms of the related leases. Depreciable lives by asset group are
as follows:
Computer and office equipment ......................3 to 5 years
Furniture and fixtures..............................4 years
Computer software...................................3 years
Leasehold improvements..............................term of lease
Normal maintenance and repair items are charged to costs and expenses
as incurred. The cost and accumulated depreciation of property and equipment
sold or otherwise retired are removed from the accounts and gain or loss on
disposition is reflected in net income in the period of disposition.
(d) Intangible Assets
Intangible assets are amortized on a straight-line basis over their
estimated useful lives as follows:
Acquired technology.......................... 5 to 7 years
Goodwill......................................... 10 years
(e) Product and Development Expenditures
Product and development costs are expensed as incurred.
(f) Impairment of Long-Lived Assets and Long-Lived Assets to be
Disposed Of
The Company reviews long-lived assets and certain identifiable
intangibles for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset to future undiscounted operating cash flows expected to be generated by
the asset. If such assets are considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of the assets
exceeds the fair value of the assets. Assets to be disposed of are reported at
the lower of the carrying amount or fair value less costs to sell. No assets
were determined to be impaired and were not disposed of for the three months
ended September 30, 2001 and September 30, 2000.
(g) Financial Instruments
The carrying values of cash, accounts receivable, accounts payable,
accrued liabilities, capital leases, current portion of notes payable and
debenture approximated fair value due to the short maturity of those
instruments. All financial instruments are held for purposes other than trading.
(h) Income Taxes
Income taxes are accounted for under the asset and liability method.
The asset and liability method recognizes deferred income taxes for the tax
consequences of "temporary differences" by applying enacted statutory tax rates
applicable to future years to differences between the financial statement
carrying amounts and the tax bases of existing assets and liabilities. The
effect on deferred taxes of a change in tax rates is recognized in income in the
period that includes the enactment date.
Deferred tax assets are to be recognized for temporary differences that
will result in deductible amounts in future years and for tax carryforwards if,
in the opinion of management, it is more likely than not that the deferred tax
assets will be realized.
(i) Accounting for Stock Options
The Company applies the intrinsic value-based method of accounting
prescribed by Accounting Principles Board (APB) Opinion No. 25, "Accounting for
Stock Issued to Employees," and related interpretations, in accounting for its
fixed plan employee stock options. As such, compensation expense would be
recorded on the date of grant only if the current market price of the underlying
stock exceeded the exercise price. Compensation expense related to stock options
granted to non-employees is accounted for under Statement of Financial
Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation,"
whereby compensation expense is recognized over the vesting period based on the
fair value of the options on the date of grant.
(j) Revenue Recognition
During the year ended June 30, 2001, the Company changed its products
offered relating to the "Complete Store-Builder Packet" (the "New Packet").
Prior to October 2000 the revenue related to the sales of the original Store
Builder Packet were recognized over the period customers had to activate their
web site which would require the Company to perform additional services and host
the web site. Subsequent to October 1, 2000 the Company is providing customers
with the New Packet that does not require the Company to perform any additional
services. Revenue from the sale of software products is recognized upon the
delivery of the products. Revenue related to the sale of web site hosting and
banner licenses is recognized over the period representing the life of the
license and the length of the prepaid service. Revenue related to banner
advertising services is recognized over the period such advertising is usable
and revenue related to the delivery of mentoring services is recognized over the
estimated service period. The revenue recorded relating to the sale of merchant
account software is reflected net of the cost of the product paid since the
Company does not take title to the product prior to the sale.
Revenues relating to the Company's Internet Commerce Center from the
design and development of Internet Web sites and related consulting projects is
recognized using the percentage-of-completion method. Unbilled receivables
represent time and costs incurred on projects in progress in excess of amounts
billed, and are recorded as assets. Deferred revenue represents amounts billed
in excess of costs incurred, and is recorded as a liability. To the extent costs
incurred and anticipated costs to complete projects in progress exceed
anticipated billings, a loss is recognized in the period such determination is
made for the excess.
(k) Comprehensive Income
Statement of Financial Accounting Standards ("SFAS") No. 130,
"Reporting Comprehensive Income" establishes standards for reporting and
displaying comprehensive income (loss) and its components in a full set of
general-purpose financial statements. This statement requires that an enterprise
classify items of other comprehensive income (loss) by their nature in a
financial statement and display the accumulated balance of other comprehensive
income (loss) separately from retained earnings and additional paid-in capital
in the equity section of a statement of financial position. The Company has
components of other comprehensive income (loss), which are classified in the
accompanying statement of Capital deficit
(l) Business Segments and Related Information
Statement No. 131, "Disclosures about Segments of an Enterprise and
Related Information" (SFAS No. 131) establishes standards for the way public
business enterprises are to report information about operating segments in
annual financial statements. SFAS No. 131 requires enterprises to report
selected information about operating segments in interim financial reports
issued to shareholders. It also establishes standards for related disclosure
about products and services, geographic areas and major customers. It replaces
the "industry segment" concept of SFAS No.14, "Financial Reporting for Segments
of a Business Enterprise," with a "management approach" concept as the basis for
identifying reportable segments.
The Company has operated under two principal business segments
(Internet services and multimedia products). The primary business segment
(internet services) is engaged in the business of providing its customers the
ability to (i) acquire a presence on the Internet and (ii) to advertise and sell
their products or services on the Internet. A secondary business segment
(multimedia services) has been engaged in providing assistance in the design,
manufacture and marketing of multimedia brochure kits, shaped compact discs and
similar products and services intended to facilitate conducting business over
the Internet. This second segment was sold on January 11, 2001 and accordingly
is reported as discontinued operations in the accompanying consolidated
statements of operations. As a result, the Company now operates in one business
segment.
(m) Foreign Currency Translation
The financial statements of the Company's Canadian subsidiary,
StoresOnline.com, Ltd. have been translated into U.S. dollars from its
functional currency in the accompanying consolidated financial statements in
accordance with Statement of Financial Accounting Standards No. 52, "Foreign
Currency Translation." Balance sheet accounts of StoresOnline.com, Ltd. are
translated at period-end exchange rates while income and expenses are translated
at the average of the exchange rates in effect during the period. Translation
gains or losses that related to StoresOnline.com, Ltd.'s net assets are shown as
a separate component of shareholders' equity and comprehensive income (loss).
There were no gains or losses resulting from realized foreign currency
transactions (transactions denominated in a currency other than the entities'
functional currency) during the three months ended September 30, 2001 and
September 30, 2000.
(n) Per Share Data
Basic earnings (loss) per share is computed by dividing net income
(loss) available to common shareholders by the weighted average number of common
shares outstanding during the period. Diluted earnings (loss) per share reflects
the potential dilution that could occur if securities or other contracts to
issue common stock were exercised or converted into common stock or resulted in
the issuance of common stock that then shared in the earnings of the entity.
Unexercised stock options to purchase 2,626,226 and 4,789,065 shares of
the Company's common stock and unexercised warrants to purchase 882,346 and
2,319,003 shares of the Company's common stock at September 30, 2001, and 2000,
respectively, were not included in the per share computations because their
effect would have been antidilutive.
(o) Use of Estimates
Management of the Company has made a number of estimates and
assumptions relating to the reporting of assets and liabilities and the
disclosure of contingent assets and liabilities at the balance sheet date, and
the reporting of revenues and expenses during the reporting periods to prepare
these financial statements in conformity with generally accepted accounting
principles. Actual results could differ from those estimates.
(p) Reclassifications
Certain amounts have been reclassified to conform to current year
presentation.
(q) Discontinued Operations
APB Opinion No. 30 states that discontinued operations refers to the
operations of a segment of a business that has been sold, abandoned, spun off,
or otherwise disposed of or, although still operating, is the subject of a
formal plan for disposal. In accordance with APB Opinion No. 30, the results of
continuing operations are reported separately from discontinued operations and
any gain or loss from disposal of a segment is reported in conjunction with the
related results of discontinued operations.
(r) Advertising Costs
The Company expenses costs of advertising and promotions as incurred.
Advertising expenses included in selling and marketing expenses for the three
months ended September 30, 2001 and 2000 were approximately $1.3 million and
$1.7 million, respectively.
(s) Commission Expense
Commission expense relating to third-party telemarketing activity is
recognized as incurred.
(t) Recently Issued Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statements of Financial Accounting Standards No. 141, "Business Combinations"
and No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets", which
establishes new standards for the treatment of goodwill and other intangible
assets. SFAS 142 is effective for fiscal years beginning after December 15, 2001
and permits early adoption for companies with a fiscal year beginning after
March 15, 2001. SFAS 142 prescribes that amortization of goodwill will cease as
of the adoption date. Additionally, the Company will be required to perform an
impairment test as of the adoption date, annually thereafter, and whenever
events and circumstances occur that might affect the carrying value of these
assets. The Company has not yet determined what effect, if any, the impairment
test of goodwill will have on the Company's results of operations and financial
position. In addition, subsequent to June 2001, SFAS 143 and SFAS 144 have been
issued, but they are not effective until fiscal years beginning after June 15,
2002 and December 15, 2001, respectively and the Company is evaluating the
impact of these pronouncements on financial position and results of operations.
(3) Going Concern
The accompanying financial statements have been prepared on the basis
that the Company will continue as a going concern, which contemplates the
realization of assets and satisfaction of liabilities in the normal course of
business. The Company has incurred losses since its inception and a cumulative
net loss of approximately $69 million through September 30, 2001. At September
30, 2001 the Company had a working capital deficit of $2,229,471 and a capital
deficit of $ 302,112. For the three months ended September 30, 2001 and 2000 the
Company recorded negative cash flows from continuing operations of $1,336,320
and $4,250,785, respectively. The Company has historically relied upon private
placements of its stock and issuance of debt to generate funds to meet its
operating needs. Management's plans include the raising of additional debt or
equity capital and, in addition, subject to shareholder approval, the merger of
the Company with Category 5 Technologies (see Note 8). However, there can be no
assurance that additional financing will be available on acceptable terms, if at
all. The Company continues to work to improve the strength of its balance sheet
and has restructured its ongoing operations in an effort to improve
profitability and operating cash flow. If adequate funds are not generated, the
Company may be required to further delay, reduce the scope of, or eliminate one
or more of its products or obtain funds through arrangements with collaborative
partners or others that may require it to relinquish rights to all or part of
the intellectual property of its Stores Online software or the Internet Commerce
Center or control of one or more of its businesses. The consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
(4) Debentures
In July 2000, the Company entered into a securities purchase agreement
with King William, LLC. Under the terms of the agreement, the Company issued to
King William an 8% convertible debenture due July 31, 2003 in the principal
amount of $4.5 million. The debenture was convertible into the number of shares
of our common stock at the lower of $1.79 or a conversion rate of 80% of the
average market price of the common stock during any three non-consecutive
trading days during the 20 trading days prior to conversion. The purchase price
for the debenture was payable in two tranches. The first tranche of $2.5 million
was paid at the closing in July 2000. The value of the beneficial conversion
feature on the $2.5 million that has been drawn down was recorded as additional
paid in capital and interest expense of $884,000 for the quarter ended September
30, 2000, as the convertible debentures were immediately exerciseable.
In connection with the securities purchase agreement, the Company
issued to King William a warrant to purchase 231,000 shares of the Company's
common stock. In connection with the issuance of the debenture, the Company also
issued to Roth Capital Partners, Inc., a warrant to purchase 90,000 shares of
common stock and to Carbon Mesa Partners, LLC, a warrant to purchase 10,000
shares of common stock. Each of the warrants is exercisable for five years from
the date of issue, at an exercise price of $1.625 per share and with cashless
exercise and piggyback registration rights. The fair value of the warrants has
been determined to equal $371,000. Of the $371,000, $259,000 is accounted as
additional paid in capital and debt discount and was amortized over the life of
the debt. The remaining balance is accounted for as debt issuance costs included
in other assets and was amortized over the life of the debt.
Effective as of January 25, 2001, the Company reached an agreement with
King William LLC to restructure the debenture. As of the date of the
Restructuring Agreement the Company was in breach and/or violation of the
Purchase Agreement, the Debenture, the King William Warrant Agreement, the
Registration Rights Agreements and the Equity Agreement. However, pursuant to
the terms of the Restructuring Agreement the holder of the Convertible Debenture
has waived all of these defaults as of the date of the Restructuring Agreement.
Under the terms of the Restructuring Agreement the agreements were terminated
effective as of the date of the Restructuring Agreement and no termination
payment or additional warrants were issued in connection therewith.
Under the terms of the Restructuring and Amendment Agreement the second
tranche of the debenture will not be available to the Company. The Company
agreed to repay the full amount of the Debenture plus a 15% premium ($375,000)
with respect to the original principal amount in ten payments. As of the date of
the Restructuring and Amendment Agreement the current principal amount including
accrued and unpaid interest was $2,972,781. Additionally, the Company has
allowed King William to retain the right to convert any or all portions of the
outstanding debt to equity, but only after the stock has traded at or above
$3.00 for twenty consecutive trading days, or if the Company does not make a
required payment of principal. Warrants already earned by King William were
repriced at $.25 per share and King William was issued a warrant for an
additional 269,000 shares of common stock at $.25 per share. The incremental
fair value of the repricing of the warrants and the issuance of the new warrants
was $9,009 and $129,927, respectively. These costs were classified on the
balance sheet as debt restructuring costs and were being amortized over the life
of the debt. The initial payment of $250,000, as called for by the Restructuring
and Amendment Agreement, was made during the first week of February 2001. A
second payment to be paid on February 28, 2001 was not made.
In May 2001 King William elected to convert $200,000 of the principal
and accrued and unpaid interest of the debenture (Conversion Amount) into
800,000 shares of Common Stock of the Company, at a conversion price of $.25 per
share. The Conversion Amount was credited toward the payment of $250,000 due on
February 28, 2001, with the balance plus interest accrued to be paid on March
10, 2002. In addition, in May 2001, the Company entered into a Waiver Agreement
with King William, LLC to amend certain of the terms of the Restructuring
Agreement and to waive certain existing defaults under the Restructuring and
Amendment Agreement. The waiver agreement amended the Restructuring Agreement
payment schedule to postpone the remaining April 2001 payment of $247,278 to
February 2002 and the May 2001 payment of $247,278 to March 2002. As of the date
of the Waiver Agreement King William has withdrawn and waived all defaults and
violations.
Effective July 11, 2001 the Company and King William entered into a
Second Restructuring Agreement. The Company agreed to pay, and King William
agreed to accept, in full and final satisfaction of the Debenture at a closing
effective September 10, 2001, (i) a cash payment of $100,000, (ii) a $400,000
promissory note of the Company due August 2004 bearing interest at 8% per annum
and (iii) 2,800,000 shares of the Company's common stock. No accrued interest
was payable in connection with these payments. King William has agreed to
certain volume limitations relating to the subsequent sale of its shares of the
Company's common stock and has also agreed to forgive the promissory note if the
Company meets certain specific requirement including a minimal amount
($2,250,000) of proceeds King William receives from its sale of Company common
stock. No gain or loss on the exchange of shares for debt was recorded in the
accompanying financial statements.
(5) Convertible Long Term Notes Payable
In January and April 2001, the Company issued long term Convertible
Promissory Notes ("Notes") in a private placement offering totaling $2,076,500.
The Notes mature on July 1, 2004 and interest accrues at the rate of eight
percent (8%) per annum. The Notes are convertible prior to the Maturity Date at
the option of the Holder any time after July 1, 2001, or by the Company at any
time after July 1, 2001 upon certain conditions as detailed in the Convertible
Promissory Notes. The Notes are convertible into shares of common stock of the
Corporation by dividing the Note balance on the date of conversion by $.25,
subject to Conversion Price Adjustments as defined in the agreement. The
relative fair value of this Beneficial Conversion Feature of the notes has been
calculated to be $1,347,480 and has been recorded as debt discount on the
balance sheet, and is amortized over the life of the Notes.
In connection with the sale of the Notes, the Company issued a warrant
to purchase a share of the Company's common stock at an exercise price of $.50
per share for every two shares of Common Stock into which the Note is originally
convertible. The Company issued a total of 3,661,000 warrants in connection with
the sale of the Notes, with a date of expiration not to exceed sixty calendar
days following the commencement date of the warrants. The relative fair value of
the warrants has been determined to be $512,540 and has been recorded as debt
discount on the balance sheet and is amortized over the life of the Notes.
The debt discounts of $1,347,480 and $512,540 for the beneficial
conversion feature and the warrants, respectively, have been netted against the
$2,076,500 balance of the Notes on the Balance Sheet and are being amortized
over the life of the notes.
As of September 30, 2001, note holders holding $1,801,083 of aggregate
principal and accrued interest, had exercised their right to convert both
principal and accrued interest into 7,204,334 shares of common stock. As of
September 30, 2001, note holders holding approximately $350,000 of aggregate
principal and accrued interest had not exercised their right to convert both
principal and accrued interest into approximately 1,388,000 shares of common
stock. As of September 30, 2001, the balance of the notes on the balance sheet
net of the debt discount on the notes was $65,365 after recording the expense
related to the September 2001 conversion.
(6) Shareholders' Equity
During the three-month period ended September 30, 2001, the Company
issued 6,910 shares of common stock upon the exercise of employee stock options.
During the three months ended September 30, 2001 the Company issued
6,705,924 shares of common stock pursuant to a private placement agreement.
On August 1, 2001, the Company entered into an agreement with
Electronic Commerce International ("ECI"), a company owned by a director of and
the president of Netgateway, Inc., pursuant to which, among other matters, the
Company agreed to issue to them a total of 831,915 shares of common stock of the
Company at a price of $.30 per share in exchange for the release by ECI of trade
claims by them against the Company totaling $249,575 in the aggregate. In
connection with the exchange, the Company recorded a charge of $199,657,
representing the difference between the market value and the exchange rate,
which is included in the cost of goods sold.
(7) Discontinued Operations
On January 11, 2001, the Company sold IMI, Inc., dba Impact Media, a
wholly-owned subsidiary, for $1,631,589 to Capistrano Capital, LLC. The
principal shareholder of Capistrano subsequently became a shareholder of the
Company. The Company received from Capistrano Capital, LLC. a cash payment of
$300,000, with the balance owing of $1,331,589 in the form of a long-term note,
payable by Capistrano Capital, LLC. With the purchase, Capistrano Capital
assumed responsibility for all current and future funding obligations required
by Impact. Since the Company has yet to receive required payments previously due
on the note, and IMI, Inc. has not been successful in obtaining additional
financing, the Company has reserved the entire $1,331,589 note balance at
September 30, 2001.
Operating results for the three months ended September 2000 include the
operating activity of IMI, Inc. Certain information with respect to discontinued
operations is summarized as follows:
(8) Subsequent Events
In October 2001, the Company entered into an Agreement and Plan of
Merger with Category 5 Technologies, Inc., pursuant to which, subject to
stockholder approval, the Company will be acquired through a merger of a
subsidiary of Category 5 Technologies with and into the Company. In the merger
each share of the Company's common stock will be converted into .181818 shares
of Category 5 Technologies, Inc. for each share of common stock.
On November 9, 2001 the Company was served with a summons and complaint
from NFCC seeking 250,000 shares of the Company's common stock and damages in
the amount of up to $1,000,000 as to be determined at trial. It is not possible
at this time to determine the probable outcome of the action.
On November 13, 2001, the Company issued 2,333,333 shares of the common
stock of the Company, and recorded an amount of $150,000 in its accounts
payable, pursuant to the October 10, 2001 agreement with SBI E-2 Capital (USA)
Ltd., for services as a financial advisor to the Company in connection with the
acquisition of the Company by Category 5 Technologies. A member of the Company's
Board of Directors is a managing director of SBI E-2 Capital (USA) Ltd.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
This management's discussion and analysis of financial condition and
results of operations and other portions of this Quarterly Report on Form 10-Q
contain forward-looking information that involves risks and uncertainties. Our
actual results could differ materially from those anticipated by this
forward-looking information. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed or referred to in
the Annual Report on Form 10-K for the year ended June 30, 2001, filed on
October 15, 2001, under the heading Information Regarding Forward-Looking
statements and elsewhere. In addition, set forth below under the heading "Risk
Factors" is a discussion of certain additional risks associated with the
proposed acquisition of us by Category 5 Technologies, Inc. Investors should
review this quarterly report in combination with our Annual Report on Form 10-K
in order to have a more complete understanding of the principal risks associated
with an investment in our common stock. This management's discussion and
analysis of financial condition and results of operations should be read in
conjunction with our financial statements and related notes included elsewhere
in this quarterly report on Form 10-Q.
General
In October, we entered into an Agreement and Plan of Merger with
Category 5 Technologies, Inc., pursuant to which, subject to stockholder
approval, we will be acquired through a merger of a subsidiary of Category 5
Technologies with and into our company. In the merger, each share of our common
stock will be converted into .181818 shares of common stock of Category 5
Technologies, Inc.
The financial statements for the three-month period ended September 30,
2000 have been reclassified to conform to current year presentation, including
disclosures for discontinued operations.
For the last two quarters of our fiscal year ended June 30, 2001 and
for the current quarter ended September 30, 2001 we have reported net income
even though the full fiscal year ended June 30, 2001 showed a net loss of
$3,638,736. In spite of the profitable operations for the past three quarters,
we continue to have a negative working capital ratio and cash flow from
operations in each of the last three quarters has been negative. As discussed in
our annual report on Form 10-K and elsewhere in this filing, our liquidity still
must be improved.
The current economic slow down in the United States and the effect of
the events of September 11, 2001 have adversely impacted our revenues and
operations. Finding the necessary liquidity to continue operations remains a
high priority for our management team.
Fluctuations in Quarterly Results and Seasonality
In view of the rapidly evolving nature of our business and our limited
operating history, we believe that period-to-period comparisons of our operating
results, including our gross profit and operating expenses as a percentage of
net sales, are not necessarily meaningful and should not be relied upon as an
indication of future performance.
While we cannot say with certainty the degree to which we experience
seasonality in our business because of our limited operating history, our
experience to date indicates that we experience lower sales during our first and
second fiscal quarters. We believe this to be attributable to summer vacations
and the Thanksgiving and December holiday seasons.
Results of Operations
Three-month period ended September 30, 2001 compared to the three-month
period ended September 30, 2000
Revenue
Revenues for the three-month period ended September 30, 2001, our first
fiscal quarter of fiscal year 2002, increased to $11,634,043 from $7,425,857 in
the three month period ended September 30, 2000, an increase of 57%. Operating
revenues are from the design and development of Internet web sites and related
consulting projects, revenues from our Internet training workshops (including
attendance at the workshop, rights to activate web sites and hosting), sales of
banner advertising, web traffic building products, mentoring and transaction
processing. We expect future operating revenues to be generated principally from
our Internet training workshops following a business model similar to the one
used in the latter part of fiscal year 2001. The Internet environment continues
to evolve, and we intend to offer future customers new products as they are
developed. We anticipate that our offering of products and services will evolve
as some products are dropped and are replaced by new and sometimes innovative
products intended to assist our customers achieve success with their
Internet-related businesses.
Formerly we reported product sales that came from our subsidiary, IMI,
Inc. On January 11, 2001, we sold IMI for $1,631,589, including $1,331,589 owed
to us by IMI at the time of the sale. We received a cash payment of $300,000 and
a promissory note for the balance. Accordingly, IMI operations from prior
periods are now reported as discontinued operations in the accompanying
consolidated statement of operations.
The increase in revenues from fiscal 2000 to 2001 can be attributed to
a change in the business model and products for our Galaxy Mall Internet
workshop training business and an increase in the prices charged for the
products delivered at the workshop.
Since October 1, 2000, the product sold to our customers at our
Internet training workshop has been a "Complete Store-Building Packet" which
contains a CD- ROM that includes the necessary computer software, links to the
Internet and instructions to allow the customer to construct its storefront
without any additional services being supplied by us. If additional assistance
is required, we provide it for a fee and charge the customer after the services
are rendered. The customer may host the storefront with us or any other provider
of Internet hosting services. If the customer elects to prepay us for hosting,
we recognize the revenue as the service is rendered. Under this new model, we
now recognize most of the revenue generated at our Internet workshops at the
time of sale. We anticipate enhanced revenues and earnings during the second
fiscal quarter of fiscal year 2002 as well, since the amount of revenue deferred
from each Internet training workshop sale will be greatly reduced and the
revenue from prior period sales will continue to be recognized during the second
fiscal quarter of this year.
We anticipate that the beneficial deferred revenue impact due to the
October 2000 change in our product offerings will continue only during the
second fiscal quarter of fiscal year 2002. Thereafter we anticipate that the
amount of revenue recognized from earlier quarters will be approximately equal
to that deferred into future periods. If we enjoy a strong growth rate, it is
possible that during any one quarter the amount of revenue deferred into future
periods will exceed that recognized during the same quarter from sales in prior
periods.
The price of the Complete Store Builder Packet sold at the workshop
during the three month period ended September 30, 2001 was $2,400 compared to
the product it replaced that was sold for $1,950 during the three month period
ended September 30, 2000. This is a 23% increase in the revenue generated from
each unit sale.
The number of workshops conducted for the current fiscal quarter
decreased to 73 from 95 in the fiscal quarter ended September 30, 2000. Due to
our lack of cash, it was necessary to reduce the number of workshops held and
use our limited resources to attract the maximum number of attendees at these
workshops. We do not expect this trend to continue, based on our plan to expand
into international operations, which is anticipated to result in an increased
number of workshops. During October and November 2001, we have been conducting
test workshops in New Zealand and Australia for the first time, and we will
consider other geographical areas after we complete our evaluation of the
results of the workshops conducted in New Zealand and Australia.
Historically, between 32% and 38% of the primary attendees (not
including their guests) at our workshops make a purchase. This ratio remained
approximately the same during the current fiscal quarter.
Gross Profit
Gross profit is calculated as revenue less the cost of sales, which consists of
the costs to conduct Internet training workshops, program customer storefronts,
provide customer support and the cost of tangible products sold. Gross profit
for the fiscal quarter ended September 30, 2001 increased to $10,044,474 from
$5,235,949 in the comparable quarter of the prior fiscal year. The increase in
gross profit is the result of several factors:
o The increase in revenues for the period.
o The savings realized in programming and providing customer
support because of the delivery of the "Complete Store-Building
Packet" as the product sold at the workshop. The Complete
Store-Building Packet contains powerful tools so our customers
can develop their eCommerce-enabled storefront with no assistance
from us. Prior technology was not as user friendly and thus
required us to spend more resources assisting our customers to
publish their storefronts.
o The cost of conducting our Internet training workshops remained
relatively constant per workshop, while the selling price of the
products delivered at the workshops increased.
o Our cost to provide on line, real time credit card processing
decreased.
o The percentage of attendees at the workshops who purchased the
Complete Store-Building Packet remained approximately the same as
it had been in the former business model.
Gross margin percentages increased for the fiscal quarter ended
September 30, 2001 to 86% of revenue from 71% of revenue for the fiscal quarter
ended September 30, 2000. We anticipate that gross profit as a percentage of
sales will decline in future quarters. This decline is expected because of the
effect of the deferred revenue amortization discussed above. We believe the
achievable gross profit percentage, after the second fiscal quarter of fiscal
year 2002, will be similar to what was experienced by our Galaxy Mall subsidiary
without regard to the amortization of the deferred revenue that was
approximately 60% to 70%.
Product Development
Product development expenses consist primarily of payroll and related
expenses for development, editorial, creative and systems personnel as well as
outside contractors. Product development expenses for the quarter ended
September 30, 2001 were $53,400. They consisted of work on the Stores On Line,
version 4 product which is used in the "Complete Store Building Packet" sold at
our Internet training workshops. During the three-month period ended September
30, 2000 they were $1,214,324 and consisted mostly of work on the Internet
Commerce Center (ICC). Most of the development expenses for the ICC were
incurred prior to December 2000. We have completed the basic development of the
ICC, as redefined by us.
We intend to make enhancements to our technology as new methods and
business opportunities present themselves, but our business model currently
contemplates that in most cases we will pass these costs on to our customers. We
will undertake additional development projects as the needs are identified and
as the funds to undertake the work are available.
Selling and Marketing
Selling and marketing expenses consist of payroll and related expenses
for sales and marketing and the cost of advertising, promotional and public
relations expenditures and related expenses for personnel engaged in sales and
marketing activities. We also contract with telemarketing companies and
commissions earned by them are included. Selling and marketing expenses for the
quarter ended September 30, 2001 decreased to $3,611,796 from $6,848,155 in the
comparable three-month period. The decrease in selling and marketing expenses is
primarily attributable to the closing of our Business to Business (B2B) and
Cable Commerce divisions. As reported in our most recent annual report on Form
10-K and earlier filings when the management change took place in January 2001
sales and marketing activities for these two divisions were terminated because
neither had achieved revenues sufficient to generate a positive cash flow.
During the three-month period ended September 30, 2000 there were approximately
$886,000 in selling and marketing expenses associated with our B2B and Cable
Commerce divisions compared to none during the current fiscal quarter.
Selling and marketing expenses as a percentage of sales decreased to
31% of revenues for the current fiscal quarter from 92% in the comparable
three-month period. We expect selling and marketing expenses to increase as a
percentage of revenues in the future due to the effects of the deferred revenue
explained above.
General and Administrative
General and administrative expenses consist of payroll and related
expenses for executive, accounting and administrative personnel, professional
fees, bad debts and other general corporate expenses. General and administrative
expenses for the three-month period ended September 30, 2001 increased to
$2,400,987 from $2,288,710 in the comparable prior year period. This increase is
primarily attributable to an increase in bad debts expense. Salaries during the
current quarter were less than in the comparable period of the prior fiscal
year.
Bad debt expense consists of actual and anticipated losses resulting
from the extension of credit terms to and the acceptance of credit cards from
our customers when they purchase products at our Internet training workshops. We
encourage customers to pay for their purchases by check or credit card since
these are the least expensive methods of payment for our customers, but we do
offer installment contracts with payment terms up to 24 months as an
alternative. We offer these contracts to all workshop attendees not wishing to
use a check or credit card regardless of their credit history, because it is our
policy to assist everyone who attends a workshop and wishes to become a Galaxy
Mall merchant to achieve their goal. A down payment at the time of purchase is
required. These installment contracts are sold to various finance companies if
our customer has a credit history that meets the finance company's criteria. If
not sold, we carry the contract and out-source the collection activity.
Bad debt expense was $845,000 in the current fiscal quarter ended
September 30, 2001 compared to $321,847 in the comparable period of the prior
fiscal year. The increase is principally due to the increase in the number of
installment contracts accepted by us as the sales volume grew and an increasing
portion of our customers elected to take advantage of the financing alternatives
offered by us rather than to pay in cash or by credit card. At the time of a
contract sale to a finance company 20% of the sales price is placed in a reserve
account held by the finance company. If our customer does not make its payments
on the contract, the finance company may charge the reserve for the unpaid
balance previously funded to the extent there are funds available in the reserve
account. At maturity of the customer contract, the net balance of the reserve is
returned to us. One of the finance companies holding a reserve that will be due
to us when the contracts are collected has experienced financial difficulties
and may not be able to return these reserves. We therefore established a loss
provision of approximately $950,000 during the fiscal year ended June 30, 2001.
Depreciation and Amortization
Depreciation and amortization expenses consist of a systematic charge
to operations for the cost of long-term equipment and a write down of the
goodwill associated with the purchase of other businesses. Depreciation and
amortization expenses for the three-month period ended September 30, 2001
decreased to $151,628 from $410,168 in the three-month period ended September
30, 2000.
Interest Expense
Interest expense for the fiscal quarter September 30, 2001 increased to
$1,593,128 from $945,430 in the prior fiscal year. We included in interest
expense in the current fiscal quarter a one-time charge of $437,474 relating to
the conversion of an 8% convertible debenture issued to King William, LLC into
common stock and a charge of $594,217 relating to the conversion into common
stock of convertible long term notes held by investors who participated in a
private placement of the notes in January and April 2001. Upon conversion of
these items the debt discount previously recorded was written off in the current
quarter instead of being amortized over the life of the notes
We have repaid the various debt instruments, which created the interest
expense for the three-month ended September 30, 2000.
Discontinued Operations
In January 2001, we sold our subsidiary, IMI, Inc. to a third party. As
a result, the loss from discontinued operations is listed on a separate line
item in the statement of operations.
Liquidity and Capital Resources
Cash
We have incurred substantial losses in the past and may in the future
incur additional losses. At September 30, 2001, we had a working capital deficit
of $2,229,471 and at June 30, 2001, we had a working capital deficit of
$11,352,352. Our capital deficit was $302,112 and $9,306,829 at September 30,
2001 and June 30, 2001, respectively. We generated revenues from continuing
operations of $11,634,043 for the three-month period ended September 30, 2001
and $7,425,857 for the three-month period ended September 30, 2000. For the
quarter ended September 30, 2001 we had a net income of $2,335,307 and for the
quarter ended September 30, 2000, we incurred a net loss of $6,680,035. For the
quarter ended September 30, 2001 and the quarter ended September 30, 2000, we
recorded negative cash flows from continuing operations of $730,865 and
$4,250,785, respectively.
At September 30, 2001, we had $109,728 cash on hand, a decrease of
$39,437 from June 30, 2001.
Net cash used in operating activities was $1,336,320 for the fiscal
quarter ended September 30, 2001. Net cash used in operations was primarily
attributable to net income of $2,335,308 from continuing operations plus
non-cash charges, but off set by a decrease in deferred revenue of $3,753,007,
an increase in accounts receivable of $1,641,089, and a decrease in accounts
payable, accrued expenses and other liabilities of $834,754. The non-cash
charges include: (i) amortization of debt issue costs of $642,019 relative to
the King William debenture and warrants issued in January and April 2001, and
(ii) amortization of debt discount of $1,482,422 relative to the conversion of
the King William debenture and the beneficial conversion feature of the
convertible notes. The amortization of debt issue costs and debt discount was
accelerated due to the conversion of the King William debenture and the
convertible notes during the current quarter.
Net cash provided by financing activities for the fiscal quarter ended
September 30, 2001 was $1,303,745.
As a result of our inability to sell a sufficient number of the
installment contracts generated by our Galaxy Mall Internet workshop training
business we do not have sufficient cash from operating activities to meet our
immediate working capital and cash requirements. We have historically relied
upon private placements of our stock and issuance of debt to generate funds to
meet our operating needs. We have sought and will continue to seek to raise
capital, however, there can be no assurance that additional financing will be
available on acceptable terms, if at all. If adequate funds are not generated,
we may be required to further delay, reduce the scope of, or eliminate one or
more of our products or obtain funds through arrangements with collaborative
partners or others that may require us to relinquish rights to all or part of
the intellectual property of our StoresOnLine software or the Internet Commerce
Center or control of one or more of our businesses.
In May 2001 we began a private placement of unregistered common stock
at $.30 per. As of November 8, 2001, net proceeds to us from the offering were
approximately $2,800,000, of which $240,000 resulted from one of our officers
exchanging a loan due him for shares in the private placement. The private
placement will continue into the second fiscal quarter.
Accounts Receivable
Accounts receivable, both current and long-term, net of allowance for
doubtful accounts, was $3,731,141 at September 30, 2001 compared to $2,090,051
at June 30, 2001. This increase is due to a larger portion of our sales at the
Internet training workshops being financed through installment sales contracts.
We have in the past sold, on a discounted basis, a portion of these installment
contracts to third party financial institutions for cash. Because these
financial institutions are small, they are limited in the quantities of
contracts they can purchase due to limitations on the amount of receivables they
may purchase from one person imposed on them by their investors. In addition,
the institution we worked with most closely in prior years has experienced
financial difficulties and dramatically reduced its level of purchases. As a
result, we are seeking to develop relationships with other potential purchasers
of these installment contracts. In the interim, our inability to sell our
installment contracts at historic levels has had a material negative impact on
our near-term liquidity and cash position.
Other assets relating to our installment contract sales at September
30, 2001 were $354,042 net of an allowance for doubtful accounts of $1,618,110.
When installment contracts are sold, the purchaser holds approximately 20% of
the of the purchase price in a reserve that will be returned to us if the
contracts are paid in full by our customer. If the customer fails to pay, the
purchaser my charge this reserve account for the deficiency. Our obligation to
accept such charge backs is limited to the amount in the reserve account. One of
the purchasers holding such a reserve is having financial difficulties and
therefore we have established an allowance for doubtful accounts of
approximately $950,000 to provide for the possibility that the reserve funds may
not be returned to us according to the terms of our contract with them.
Delisting of Common Stock
On January 10, 2001, our common stock was delisted from the NASDAQ
National Market, and began to trade on the National Association of Securities
Dealers OTC Electronic Bulletin Board. The delisting of our common stock has had
an adverse impact on the market price and liquidity of our securities and has
adversely affected our ability to attract additional investors. This has a
material adverse effect on our liquidity because the sale of additional shares
of our common stock is currently the principal potential source of additional
funds required to operate our businesses.
Arrangements with King William, LLC
On September 10, 2001 King William exchanged the remaining balance of
the convertible debenture into 2,800,000 shares of our common stock, a cash
payment of $100,000 and note due on August 15, 2004 in the amount of $400,000.
Accounts Payable
Accounts payable at September 30, 2001, totaled $1,414,068 as compared
to $2,663,066 at June 30, 2001 and compared to $4,708,716 as of March 31, 2001.
The reduction since March is primarily due to the settlement agreements reached
with vendors as described above funded with proceeds from the sale of
convertible notes, common stock and unsecured loans from certain of our
officers. Our business operations are dependent on the ongoing willingness of
our suppliers and service providers to continue to extend their payment terms
until we resolve our current liquidity problems. A number of suppliers and
service providers now require payment in advance or on delivery.
Deferred Revenue
Deferred revenue at September 30, 2001 totaled $2,280,585 as compared
to $6,033,592 at June 30, 2001. We recognize deferred revenue as our services
are rendered or when the time period in which customers have the right to
receive the services expires. The decrease from the prior fiscal year end is the
result of a change in the products offered starting October 1, 2000 at our
Internet training workshops.
We changed the product offered at our GalaxyMall Internet workshop
training business and since October 1, 2000, have delivered a "Complete
Store-Building Packet" which contains a CD-ROM that includes the necessary
computer software, Internet links and instructions to allow the customer to
construct its storefront without any additional services being supplied by us.
If additional assistance is required, we will provide it for a fee and charge
the customer after the services are rendered. The customer may host the
storefront with us, or any other provider of Internet hosting services. If the
customer elects to prepay us for hosting, we will recognize the revenue as the
service is rendered.
Under this new model, we now recognize most of the revenue generated at
our Internet workshops at the time of sale. We anticipate that revenues and
earnings will be enhanced during the second fiscal quarter of fiscal year 2002
since the amount of revenue deferred from each Internet workshop sale will be
greatly reduced and the revenue from prior period sales will continue to be
recognized during this and future periods.
Capital Deficit
Total capital deficit decreased to $302,112 during the current fiscal
quarter from $9,306,829 at June 30, 2001. This mainly resulted from additions to
paid-in capital because of the conversion of debentures and long term notes into
common stock, the sale of common stock in a private placement at $0.30 per share
and the net income for the fiscal quarter ended September 30, 2001. (See the
Statement of Capital Deficit in the financial statements.)
Financing Arrangements
We accept payment for the sales made at our Galaxy Mall Internet
training workshops by cash, credit card, installment contract or a third party
leasing option. As part of our cash flow management and in order to generate
liquidity, we have sold on a discounted basis a portion of the installment
contracts generated by our Galaxy Mall subsidiary to third party financial
institutions for cash. Because these finance companies are small and have
limited resources they have not been able to purchase all of the contracts we
would like to sell. See "Liquidity and Capital Resources - Accounts Receivable,"
for further information.
On September 13, 2000, we retained the services of National Financial
Communications Corp. (NFCC) for a six-month period as a nonexclusive advisor in
connection with our investor relations, in consideration for which we paid
$10,000 and gave a commitment to issue it 250,000 shares of common stock. In
October 2000, National Financial notified us that it was unwilling to perform
its obligations under its retainer agreement unless the consideration was
substantially increased. This agreement has since been terminated.
On November 9, 2001, we were served with a summons and complaint from
NFCC seeking 250,000 shares of our common stock and damages in the amount of up
to $1,000,000 as to be determined at trial. It is not possible at this time to
determine the probable outcome of the action.
Impact of Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board issued
Statements of Financial Accounting Standards No. 141, "Business Combinations"
and No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets", which
establishes new standards for the treatment of goodwill and other intangible
assets. SFAS 142 is effective for fiscal years beginning after December 31, 2001
and permits early adoption for companies with a fiscal year beginning after
March 15, 2001. SFAS 142 prescribes that amortization of goodwill will cease as
of the adoption date. Additionally, we will be required to perform an impairment
test as of the adoption date, annually thereafter, and whenever events and
circumstances occur that might affect the carrying value of these assets. We
have not yet determined what effect, if any, the impairment test of goodwill
will have on our results of operations and financial position. In addition,
subsequent to June 30, 2001, SFAS 143 and SFAS 144 have been issued, and we are
evaluating the impact these pronouncements will have on our financial position
and results of operations in future filings.
Proposed merger with Category 5 Technologies, Inc.
On October 23, 2001, we signed an Agreement and Plan of Merger with
Category 5 Technologies, Inc. (Category 5 Technologies), pursuant to which,
subject to stockholder approval, we will be acquired through a merger of a
subsidiary of Category 5 Technologies into us. In the merger, each share of our
common stock will be converted into .181818 shares of Category 5 Technologies
common stock.
Risk Factors
Set forth below and elsewhere in this Quarterly Report and in the other
documents we file with the Securities and Exchange Commission, including our
Annual Report on Form 10-K for the year ended June 30, 2001, filed on October
15, 2001, under the heading Information Regarding Forward-Looking Statements,
are risks and uncertainties that could cause our actual results to differ
materially from the results contemplated by the forward-looking statements
contained in this Quarterly Report. The risks and uncertainties identified below
are some of the additional risks associated with the proposed acquisition of our
company by Category 5 Technologies, Inc.
Risk Factors Regarding the Proposed Merger with Category 5 Technologies
Our stockholders will receive 0.181818 shares of Category 5 Technologies common
stock for each share of our common stock owned despite changes in the market
value of Category 5 Technologies common stock or our common stock.
Upon completion of the merger, each share of our common stock will be
exchanged for 0.181818 shares of Category 5 Technologies common stock. There
will be no adjustment for changes in the market price of either Category 5
Technologies common stock or our common stock. Neither we nor Category 5
Technologies are permitted to abandon the merger, nor are we permitted to
re-solicit the vote of our stockholders solely because of changes in the market
price of Category 5 Technologies common stock. Accordingly, the specific dollar
value of Category 5 Technologies common stock to be received upon completion of
the merger will depend on the market value of Category 5 Technologies common
stock at the time of completion of the merger. The share price of both Category
5 Technologies and our common stock is by nature subject to general fluctuations
in the market for publicly traded securities and has experienced significant
volatility and in addition there is only a very limited trading history for the
common stock of Category 5 Technologies. No prediction can be made as to the
market price of Category 5 Technologies common stock at the completion of the
merger or as to the market price of Category 5 Technologies common stock after
the completion of the merger.
Our officers and directors have conflicts of interest that may influence them to
support or recommend the merger.
Our officers and directors participate in arrangements that provide them
with interests in the merger that are different from, or are in addition to,
that of our shareholders. In particular, certain of our officers and employees
may enter into employment agreements with Category 5 Technologies which will
provide for, among other things, employment with Category 5 Technologies after
the merger and other payments and benefits. Shelly Singhal is a Managing
Director and Executive Vice President of SBI-E2 Capital, which has agreed to
provide significant financial services to Category 5 Technologies prior to the
completion of the merger. In addition the merger agreement provides that Donald
Danks shall have the right to designate three directors to the board of
directors of Category 5 Technologies for a period of three years.
As a result of these interests, these officers and directors could be more
likely to support or recommend to our stockholders the approval of the merger
than if they did not have these interests. Our stockholders should consider
whether these interests may have influenced these officers and directors to
support or recommend the approval of the merger.
Category 5 Technologies may have difficulty integrating our operations and
retaining important employees.
There can be no guarantee that management will be able to successfully
integrate our employees and operations following the merger and there is the
risk that Category 5 Technologies will be unable to retain all of our key
employees for a number of reasons. There also can be no assurance that any
contemplated synergies from the integration of the businesses will be realized.
The challenges involved in this integration include the following:
o the risk that the cultures of the companies will not blend;
o obtaining synergies from the customer acquisition methodologies
of the companies; and
o obtaining synergies from the companies' product and service
offerings effectively and quickly integrating technology, back
office, human resources, accounting and financial systems.
Neither we nor Category 5 Technologies have experience in integrating the
operations on the scale presented by the merger. The integration process will be
complicated and will involve a number of special risks in addition to the
challenges described above, including the possibility that management may be
distracted from regular business operations. It is not certain that the two
companies can be successfully integrated in a timely manner or at all or that
any of the anticipated benefits will be realized. Failure to effectively
complete the integration could materially harm the business and operating
results of the combined companies.
The integration of our company with Category 5 Technologies will require
substantial time and effort of key managers of Category 5 Technologies, which
could divert the attention of those managers from other matters.
The merger will place significant demands on key managers of Category 5
Technologies. Managing the integration of the two companies and the growth of
our business may limit the time available for those managers of Category 5
Technologies to attend to other operational, financial and strategic issues.
Our merger with Category 5 Technologies may be viewed as disadvantageous by
certain customers of Category 5 Technologies and our company.
Certain of Category 5 Technologies' and our existing customers and other
business partners may view the merger as disadvantageous to them. As a
consequence, the future relationship with these persons could be adversely
affected. The merger will require the consent of certain parties who have
entered into contracts with us. There can be no assurance that such consents
will be given and, if not given, that such contracts will not terminate.
Following the merger, Category 5 Technologies may not be able to retain our
employees or the employees of Category 5 Technologies.
The success of Category 5 Technologies and us will be dependent in part on
the retention and integration of management, technical, marketing, sales and
customer support personnel. There can be no assurance that the companies will be
able to retain such personnel or that the companies will be able to attract,
hire and retain replacements for employees who leave following consummation of
the Merger. The failure to attract, hire, retain and integrate such skilled
employees could have a material adverse effect on the business, operating
results and financial condition of Category 5 Technologies and us.
Category 5 Technologies' operating results may suffer as a result of the
accounting treatment of goodwill relating to its proposed combination with us.
Under generally accepted accounting principles in the United States,
Category 5 Technologies will account for the merger using the purchase method of
accounting. Under purchase accounting, Category 5 Technologies will record the
acquisition cost of our company based on the market value of Category 5
Technologies common stock issued in connection with the merger, other
consideration and the amount of direct transaction costs incurred in acquiring
us. Category 5 Technologies will allocate the total cost to the fair value of
individual assets acquired and liabilities assumed from us, with the remaining
cost being accounted for as goodwill. Under FASB 142 "Goodwill and other
Intangible Assets," goodwill will not be amortized but will be evaluated for
impairment each reporting period. The amount of the excess purchase cost
allocated to goodwill is estimated to be approximately $31.2 million. Should it
be determined that the goodwill is impaired, the write down of goodwill may
adversely affect Category 5 Technologies' results of operations in the
foreseeable future, which could cause the market value of the combined company's
common stock to decline.
If the conditions to the merger are not met, the merger will not occur.
Several conditions must be satisfied or waived to complete the merger, and
there can be no assurance that each of the conditions will be satisfied. If the
conditions are not satisfied or waived, the merger will not occur or will be
delayed, and we may lose some or all of the intended benefits of the merger.
If the merger is not completed, our stock price and future business and
operations could be harmed.
If the merger is not completed, we may be subject to the following material
risks:
o We may be required to pay Category 5 Technologies a termination
fee of $1.5 million;
o the price of our common stock may decline to the extent that the
current market price of our common stock reflects a market
assumption that the merger will be completed; and
o We will incur significant costs related to the merger, such as
legal, accounting and the fees and expenses of our financial
advisor, which costs must be paid even if the merger is not
completed.
Further, if the merger is terminated and our board of directors determines
to pursue another merger or business combination, it is not certain that we will
be able to find a partner willing to pay an equivalent or more attractive price
than that which would be paid in the merger. In addition, while the merger
agreement is in effect, and subject to limited exceptions, we and our officers,
board members and advisors are generally prohibited from soliciting, initiating
or knowingly encouraging or entering into extraordinary transactions, such as a
merger, sale of assets or other business combination, with any party other than
Category 5 Technologies.
The Merger will result in substantial costs whether or not completed.
The merger will result in significant costs to Category 5 Technologies and
us. Excluding costs associated with combining the operations of the two
companies and severance benefits and costs associated with discontinuing some
redundant business activities, direct transaction costs are estimated at
approximately $1.4 million. These costs are expected to consist primarily of
fees for investment bankers, attorneys, accountants, filing fees and financial
printing. The aggregate amount of these costs may be greater than currently
anticipated. A substantial amount of these costs will be incurred whether or not
the merger is completed.
The rights of our stockholders will be effected by the merger.
Our stockholders, as of the effective time of the merger, will become
holders of Category 5 Technologies common stock. Certain differences exist
between the rights of our stockholders under Delaware law and our Certificate of
Incorporation and Bylaws, and the rights of stockholders of Category 5
Technologies under Nevada law, the Articles of Incorporation of Category 5
Technologies and the Bylaws of Category 5 Technologies.
The merger may have a dilutive effect to stockholders.
Although the companies believe that beneficial synergies will result from
the merger, there can be no assurance that the combining of the two companies'
businesses, even if achieved in an efficient, effective and timely manner, will
result in combined results of operations and financial condition superior to
what would have been achieved by each company independently, or as to the period
of time required to achieve such result. The issuance of Category 5 Technologies
common stock in connection with the merger may have the effect of reducing
Category 5 Technologies' net income per share from levels otherwise expected and
could reduce the market price of the Category 5 Technologies common stock unless
revenue growth or cost savings and other business synergies sufficient to offset
the effect of such issuance can be achieved.
The merger with Category 5 Technologies may create an opportunity loss for us as
a stand-alone entity.
As a consequence of the merger, our stockholders will lose the chance to
invest in the development and exploitation of our products on a stand-alone
basis. It is possible that we, if we were to remain independent, could achieve
economic performance superior to that which we could achieve as a subsidiary of
Category 5 Technologies. Consequently, there can be no assurance that our
stockholders would not achieve greater returns on investment if we were to
remain an independent company.
Item 3. Quantitative and Qualitative Disclosures of Market Risk
We do not believe we have material market risk exposure. We do not
invest in market risk sensitive instruments for trading purposes. Our excess
cash is placed in short-term interest-bearing accounts or instruments that are
based on money market rates.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings.
On September 13, 2000, we retained the services of National Financial
Communications Corp. (NFCC) for a six-month period as a nonexclusive advisor in
connection with our investor relations, in consideration for which we paid
$10,000 and gave a commitment to issue it 250,000 shares of common stock. In
October 2000, National Financial notified us that it was unwilling to perform
its obligations under its retainer agreement unless the consideration was
substantially increased. This agreement was subsequently terminated.
On November 9, 2001, we were served with a summons and complaint from
NFCC seeking 250,000 shares of our common stock and damages in the amount of up
to $1,000,000 as to be determined at trial. We dispute the damages claim and are
in negotiations with NFCC relative to the shares of common stock NFCC is
seeking. It is not possible at this time to determine the probable outcome of
the action.
Item2. Changes in Securities and Use of Proceeds
Recent Sales of Unregistered Securities
Set forth below in chronological order is information regarding the
numbers of shares of common stock sold by us, the number of options issued by
us, and the principal amount of debt instruments issued by us between July 1,
2001 and September 30, 2001, the consideration received by us for such shares,
options and debt instruments and information relating to the section of the
Securities Act or rule of the Securities and Exchange Commission under which
exemption from registration was claimed. None of these securities was registered
under the Securities Act. Except as otherwise indicated, no sales of securities
involved the use of an underwriters and no commissions were paid in connection
with the sale of any securities.
On August 1, 2001, we entered into an agreement with Electronic
Commerce International, a company owned by the president of Netgateway, pursuant
to which, among other matters, we agreed to issue to them a total of 831,915
shares of our common stock at a price of $.30 per share in exchange for the
release by it of trade claims by them against us totaling $249,575 in the
aggregate. In connection with the exchange, we recorded a charge of $199,657 In
our opinion, the offer and sale of these shares was exempt by virtue of Section
4(2) of the Securities Act and the rules promulgated thereunder.
On September 10, 2001, we completed the conversion of the $2.5 million
convertible debenture held by King William and in connection therewith issued to
King William a total of 2,800,000 shares of our common stock. We believe this
transaction was exempt from registration by virtue of Sections 3(a)(9) and/or
4(2) of the Securities Act and the rules promulgated thereunder.
During the period from July 1, 2001 through September 30, 2001, we sold
by way of private placement, a total of 6,705,924 shares of our common stock for
an aggregate consideration of $2,011,776. In our opinion, the offer and sale of
these shares was exempt by virtue of Section 4(2) of the Securities Act and the
rules promulgated thereunder.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits.
2.1 Agreement and Plan of Merger among Netgateway, Inc.,
Category 5 Technologies, Inc., and C5T Acquisition
Corp., dated October 23, 2001 (Incorporated by
reference to Exhibit 2.1 to the Form S-4 Registration
Statement filed by Category 5 Technologies, Inc. on
November 9, 2001).
3.2* Amended and Restated By-Laws of Netgateway, Inc.
10.122 Second Restructuring Agreement dated as of July 11,
2001 between Netgateway, Inc. and King William, LLC
(Incorporated by Reference from our Annual Report on
Form 10-K filed on October 15, 2001).
10.123 Promissory Note from Netgateway, Inc. to King William,
LLC (Incorporated by Reference from our Annual Report
on Form 10-K filed on October 15, 2001).
10.124* Engagement Agreement dated October 10, 2001 between
Netgateway, Inc. and SBI E2-Capital (USA) Ltd.
* Filed herewith.
(b) Reports on Form 8-K
(i) Form 8-K, Item 5, filed on July 25, 2001, with respect
to press release describing conversion of debt to stock
by King William, LLC.
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.
NETGATEWAY, INC.
Date: November 19, 2001 /s/ Donald Danks
Donald Danks
Chief Executive Officer
Date: November 19, 2001 /s/ Frank C. Heyman
Frank C. Heyman
Chief Financial Officer