QUARTERLY REPORT FOR SMALL BUSINESS ISSUERS
SUBJECT TO THE 1934 ACT REPORTING REQUIREMENTS
Form 10-QSB
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarterly Period ended September 30, 2006
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission file number: 0-25594
PROTOSOURCE CORPORATION
----------------------------------------------------
(Exact name of registrant as specified in its charter)
California 77-0190772
---------- ----------
(State or other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification Number)
One Bethlehem Plaza, 4th Floor, Bethlehem, PA 18018
---------------------------------------------------
(Address of Principal Executive Offices, Zip code)
610-332-2893
------------
(Issuers' Telephone Number)
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 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 [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ]
There were 8,114,829 shares of the registrant's common stock, no par value,
outstanding as of September 30, 2006.
PROTOSOURCE CORPORATION
QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
SEPTEMBER 30, 2006
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INDEX
-----
Part I - Financial Information (unaudited):
Item 1. Condensed consolidated balance sheet -
September 30, 2006 3
Condensed consolidated statement of
operations for the nine-month and three-month
periods ended September 30, 2006 and 2005 4
Condensed consolidated statement of
stockholders' deficiency for the nine-month
period ended September 30, 2006 5
Condensed consolidated statement of cash flows
for the nine-month periods ended September 30,
2006 and 2005 6 & 7
Notes to condensed consolidated financial
statements - for the nine-month period ended
September 30, 2006 8 to 13
Item 2. Management's discussion and analysis or
plan of operations 14 to 19
Item 3. Controls and procedures 19
Part II - Other Information
Other Information 20
Signature 21
When used in this report, the words "estimate," "project," "intend," "believe"
and "expect" and similar expressions are intended to identify forward-looking
statements. Such statements are subject to risk and uncertainties that could
cause actual results to differ materially, including competitive pressures and
new product or service introductions by the Company and its competitors. Readers
are cautioned not to place undue reliance on these forward-looking statements,
which speak only as of the date hereof. The Company undertakes no obligation to
publicly release updates or revisions to these statements.
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PROTOSOURCE CORPORATION
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CONDENSED CONSOLIDATED BALANCE SHEET
SEPTEMBER 30, 2006
(unaudited)
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ASSETS
Current assets:
Cash $ 28,502
Accounts receivable - trade, net of allowance of $0 284,172
Advances to officers, net of obligations to officers 147,114
Amounts due from related party - P2i, Inc. 170,311
Prepaid expenses and other 8,984
------------
Total current assets 639,083
------------
Property and equipment, at cost, net of
accumulated depreciation and amortization of $492,985 87,494
------------
Other assets:
Goodwill - Acquisition of P2i Newspaper 375,067
Deposits 8,274
------------
Total other assets 383,341
------------
Total assets $ 1,109,918
============
LIABILITIES AND STOCKHOLDERS' DEFICIENCY
Current liabilities:
Notes payable $ 2,425,000
Current portion of obligations under capital leases 27,291
Accounts payable 61,144
Accrued expenses 1,425,079
------------
Total current liabilities 3,938,514
------------
Obligations under capital leases, non-current portion 11,544
Stock subscriptions payable 969,345
------------
Total non-current liabilities 980,889
------------
Stockholders' deficiency:
Preferred stock, Series B, no par value; 5,000,000 shares
authorized, 193,836 shares issued and outstanding 416,179
Common stock, no par value; 10,000,000 shares
authorized, 8,114,829 shares issued and outstanding 25,835,960
Additional paid-in capital 2,291,607
Accumulated deficit (32,353,231)
------------
Net stockholders' deficiency (3,809,485)
------------
Total liabilities and net stockholders' deficiency $ 1,109,918
============
See accompanying notes.
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PROTOSOURCE CORPORATION
=======================
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(unaudited)
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NINE-MONTH THREE MONTH
PERIOD ENDED PERIOD ENDED
SEPTEMBER 30, SEPTEMBER 30,
2006 2005 2006 2005
---- ---- ---- ----
Net revenues $ 1,910,331 $ 1,404,059 $ 641,945 $ 475,477
------------ ------------ ------------ ------------
Operating costs and expenses:
Cost of revenues 1,104,603 762,531 393,962 242,644
Selling, general and administrative 585,316 565,729 184,182 186,457
Depreciation and amortization 34,672 55,388 19,260 18,574
Loss on disposal of property and equipment 21,826 -- -- --
------------ ------------ ------------ ------------
Total operating costs and expenses 1,746,417 1,383,648 597,404 447,675
------------ ------------ ------------ ------------
Operating income (loss) 163,914 20,411 44,541 27,802
------------ ------------ ------------ ------------
Other income (charges):
Interest income -- 5,182 -- 1,608
Recovery of charged-off amounts 1,600 -- 1,600 --
Other income 7,441 18,148 -- 8,707
Interest expense (262,914) (282,557) (90,591) (79,027)
Other expense (6,222) -- (1,418) --
------------ ------------ ------------ ------------
Net other (charges) (260,095) (259,227) (90,409) (68,712)
Net loss ($ 96,181) ($ 238,816) ($ 45,868) ($ 40,910)
============ ============ ============ ===========
Net loss per basic and diluted share of common stock ($ -- ) ($ .01) ($ -- ) ($ -- )
============ ============ ============ ============
Weighted average number of basic and diluted
common shares outstanding 32,874,548 32,874,548 32,874,548 32,874,548
============ ============ ============ ============
See accompanying notes.
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PROTOSOURCE CORPORATION
=======================
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' DEFICIENCY
FOR THE NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2006
(unaudited)
- ----------------------------------------------------------------------------------------------------------------------------------
Preferred Stock Common Stock Additional
--------------- ------------ Paid-In Accumulated
Shares Amount Shares Amount Capital Deficit Total
--------- ------------ --------- ----------- ------------ ------------ -----------
Balance, December 31, 2005 193,836 $ 416,179 8,114,829 $ 25,835,960 $ 2,291,607 ($32,257,050) ($ 3,713,304)
Net loss
(96,181) (96,181)
Balance, September 30, 2006 193,836 $ 416,179 8,114,829 $ 25,835,960 $ 2,291,607 ($32,353,231) ($ 3,809,485)
========= ============ ============ ============ ============ ============ ============
See accompanying notes.
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PROTOSOURCE CORPORATION
=======================
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)
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NINE-MONTH PERIOD
ENDED
SEPTEMBER 30,
2006 2005
---------- ----------
INCREASE (DECREASE) IN CASH
Cash flows from operating activities:
Net loss ($ 96,181) ($238,816)
Adjustments to reconcile net loss to net cash
provided by operating activities:
Depreciation and amortization 34,672 55,388
Amortization of debt issuance costs -- 47,067
Loss on disposal of property and equipment 21,826 --
Changes in operating assets and liabilities:
Accounts receivable (27,586) (15,447)
Prepaid expenses and other assets (2,993) 12,750
Accounts payable 15,040 (34,013)
Accrued expenses 284,931 292,356
--------- ---------
Net cash provided by operating activities 229,709 119,285
--------- ---------
Cash flows from investing activities:
Acquisitions of property and equipment (55,676) (2,302)
Deposits (5,914) 4,013
Collection on notes receivable - Brand X -- 41,365
Net change in amount due related company (71,800) (62,335)
Increase in directors and employee advances (89,836) (58,851)
--------- ---------
Net cash (used in) investing activities (223,226) (78,110)
--------- ---------
Cash flows from financing activities:
Payments on obligations under capital leases (18,793) (30,780)
--------- ---------
Net cash (used in) financing activities (18,793) (30,780)
--------- ---------
Net increase (decrease) in cash (12,310) 10,395
Cash at beginning of period 40,812 39,726
--------- ---------
Cash at end of period $ 28,502 $ 50,121
========= =========
CONTINUED ON NEXT PAGE
See accompanying notes.
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PROTOSOURCE CORPORATION
=======================
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS - CONTINUED
(unaudited)
- -------------------------------------------------------------------------------------------------------------
NINE-MONTH PERIOD
ENDED
SEPTEMBER 30,
2006 2005
-------- -------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest $13,078 $ 9,336
------- -------
Income taxes $ -- $ --
------- -------
SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING ACTIVITIES
Acquisition of equipment under capital lease obligation $26,827 $ --
------- -------
See accompanying notes.
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PROTOSOURCE CORPORATION
=======================
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2006
(unaudited)
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1. Nature of Operations and Summary of Significant Accounting Policies
-------------------------------------------------------------------
Nature of operations - ProtoSource Corporation, formerly SHR Corporation
doing business as Software Solutions Company (the "Company'), was
incorporated on July 1, 1988, under the laws of the state of California.
Until May 1, 2002, the Company was an Internet service provider (ISP). The
Company provided dial-up Internet access, web hosting services and web
development services. The Company entered into an agreement on May 1, 2002
to sell substantially all of the assets pertaining to the ISP to Brand X
Networks, Inc. (see Note 3). Effective January 1, 2004, the Company
acquired P2i Newspaper, Inc. (see Note 4). P2i Newspaper, Inc. is
principally engaged in the conversion of text and graphics from print to
interactive Web content. Its clients include newspaper groups located in
the United States and the United Kingdom. P2i Newspaper is headquartered in
Bethlehem, Pennsylvania and has a data conversion center located in Kuala
Lumpur, Malaysia.
Basis of presentation - The accompanying unaudited condensed consolidated
financial statements of the Company are prepared in conformity with
generally accepted accounting principles. The disclosures presented are
sufficient, in management's opinion, to make the interim information
presented not misleading. All adjustments, consisting of normal recurring
adjustments, which are necessary so as to make the interim information not
misleading, have been made. Results of operations for the nine months ended
September 30, 2006 are not necessarily indicative of the results expected
for the full fiscal year or for any future period. It is recommended that
this financial information be read with the complete financial statements
included in the Company's Annual Report on Form 10-KSB for the year ended
December 31, 2005 previously filed with the Securities and Exchange
Commission. The accompanying condensed consolidated financial statements
have been prepared on a going concern basis, which contemplates the
realization of assets and the satisfaction of liabilities in the normal
course of business. The financial statements do not include any adjustments
relating to the recoverability and classification of recorded asset amounts
or the amount and classification of liabilities that might be necessary
should the Company be unable to continue as a going concern. The Company's
continuation as a going concern is dependent upon its ability to generate
sufficient cash flows to meet its obligations on a timely basis, to obtain
additional financing as may be required, and to generate revenues to a
level where the Company becomes profitable. These measures are imperative,
as the Company has experienced extreme cash liquidity shortfalls from
operations.
The Company's continued existence is dependent upon its ability to achieve
its operating plan. Management's plans include the following:
o Obtaining additional working capital through the sale of common stock
or debt securities.
o The ability of P2i Newspaper to successfully implement its strategic
plan as follows:
P2i Newspaper's long-term business strategy is to focus on the processing
of print content into Web content using technologically sophisticated,
database-driven, services and solutions across multiple
business-to-business verticals. The combination of on-target sales
strategies, low labor costs, a well-educated labor pool fluent in English,
and sophisticated technologies make P2i Newspaper highly competitive. The
Company intends leveraging these competitive advantages in other markets
over the next five years.
P2i Newspaper is focused on increasing market share in the newspaper
vertical and targeting government, retail, manufacturing and publishing
verticals.
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PROTOSOURCE CORPORATION
=======================
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2006
(unaudited)
- --------------------------------------------------------------------------------
1. Nature of Operations and Summary of Significant Accounting Policies -
Continued
---------------------------------------------------------------------
Newspaper
o In November 2003, P2i Newspaper made the strategic decision to
withdraw from marketing directly to new newspaper accounts in the
United States, but instead to focus on building partnerships to build
sales. The Company recognized that the conversion of print content
into Internet content was viewed by newspapers as an essential
commodity, and as such they were motivated by price as much as product
functionality and features.
o Through its partners and residual direct accounts, P2i Newspaper is
supplying or has access to over 1,600 U.S. newspapers.
Government
o The UK government has mandated that all government publications must
also be available online within the near future. P2i Newspaper is
working closely to maximize this opportunity.
o P2i Newspaper's solution has been evaluated by the city of Stockport
in the UK and has passed the established Bobby AA standards. The
Company continues to pursue business in this market sector.
Retail
o P2i Newspaper currently processes inserts for several retailers.
o In addition, the Company is in talks with retailer groups to provide
the ad and special section processing that will be incorporated into a
platform featuring newspaper content and retail inserts.
o The pricing for converting catalog and retail insert pages has fallen
dramatically over the past 18 months. P2i Newspaper believes it will
continue to fall and that the Company is perfectly positioned to
establish partnerships with media companies with a retail focus.
Manufacturing
o P2i Newspaper solutions are applicable for any business with large
volumes of frequently updated print content that is appropriate for
Internet distribution.
o Manufacturing companies are generally putting all technical manuals
online in crude PDF format.
o The potential revenue opportunity is being quantified, but is believed
to be substantial.
If management cannot achieve the above objectives, the Company may find it
necessary to dispose of assets, or undertake other actions as may be
appropriate.
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PROTOSOURCE CORPORATION
=======================
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2006
(unaudited)
- --------------------------------------------------------------------------------
1. Nature of Operations and Summary of Significant Accounting Policies -
Continued
---------------------------------------------------------------------
Principles of consolidation - The consolidated financial statements include
the accounts of the Company and P2i Newspaper LLC, its wholly-owned
subsidiary. All significant intercompany accounts and transactions have
been eliminated.
Revenue recognition - In accordance with the SEC's Staff Accounting
Bulletin No. 104, the Company recognizes service revenue when persuasive
evidence of an arrangement exists, services are performed and delivered
without defect, the price of the transaction is fixed and determinable, and
collectibility is reasonably assured.
In general, no matter the nature of a customer's business, the Company,
through its software technology at its production facilities, converts any
manner of print text and print graphics to interactive web content
accessible via the Internet. This most often is in the form of online
advertising. (i.e., A visitor to a customer's website can, if he so
chooses, interact with the ad because the Company's technology has made
that possible. The interactivity often involves various links to additional
information and possible other pertinent or interested parties or sources
behind the genesis and purpose of the ad.) This electronically processed
service is objective and readily verifiable by both parties immediately
upon delivery to a customer's website.
Only after the Company completes its conversion processing of specific
digital data (printable text and/or graphic image files) provided by the
customer and delivers the results as interactive, online web content
directly to the customer's internet website(s) does the Company identify a
measurable event for purposes of revenue recognition. The measurable,
delivered event or unit is typically identified as a "page" (or "pages") of
service provided to the customer, immediately usable by the customer and
its clients at their website(s). This process service takes place daily, 52
weeks a year, whereupon, digital files are received and processed overnight
for morning delivery. Through contractual agreement, a price is determined
and the customer is billed for each unit of service provided at the agreed
upon price. Although the Company accumulates billable revenue-recognizable
events daily, it typically waits until month end to bill for all units
delivered during the course of that month as a convenience to its
customers.
If there are any identifiable problems or defect with any "page" content,
it is typically fixed by the Company within a matter of hours. With respect
to sales returns or credits, cancellations and warranties, the inherent
nature of the type of services provided and the underlying processes
employed by the Company to create and deliver completed product to its
customers, there is no material exposure to what would be classified as
sales returns or credits. Likewise, cancellations and or warranties are not
significantly measurable in respect to the type of electronic product
(Internet website content) deliverable to the Company's customers.
Historically, there has been little to no applicable sales returns or
credits. For these reasons, the Company has no material need or basis to
make estimates for returns and allowances.
Stock-based compensation - Effective January 1, 2006, the Company adopted
Statement of Financial Accounting Standards ("SFAS") No. 123(R),
"Share-Based Payment", using the modified prospective application
transition method. The modified prospective application transition method
requires compensation cost to be recognized beginning on the effective date
(a) based on the requirements of SFAS 123R for all share-based payments
granted after the effective date and (b) based on the requirements of SFAS
123 for all awards granted to employees prior to the effective date of SFAS
123R that remain unvested on the effective date. As such, prior periods
will not reflect restated amounts. Prior to January 1, 2006, we accounted
for all of our stock option plans in accordance with Accounting Principles
Board Opinion No. 25, "Accounting for Stock Issued to Employees," and
related Interpretations. No stock-based employee compensation expense
related to stock option plans was reflected in net income or (loss) prior
to January 1, 2006.
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PROTOSOURCE CORPORATION
=======================
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2006
(unaudited)
- --------------------------------------------------------------------------------
1. Nature of Operations and Summary of Significant Accounting Policies -
Continued
---------------------------------------------------------------------
Net income (loss) per basic and diluted share of common stock - Basic net
income (loss) per share is calculated using the weighted average number of
common shares outstanding. Diluted net income (loss) per share is computed
on the basis of the weighted average number of common shares outstanding
during the period increased by the dilutive effect of outstanding stock
options using the "treasury stock" method.
Options and warrants to purchase 1,185,000 and 2,225,000 shares of common
stock at September 30, 2006 and 2005, respectively, were not included in
the computation of diluted earnings per share, since their inclusion would
be anti-dilutive or would have no effect on net income (loss) per share.
Reclassifications - Certain reclassifications have been made to the 2005
financial statement presentation for comparability with the 2006 financial
statements.
2. Recently Issued Accounting Standards
------------------------------------
In March 2005, the FASB issued FASB Interpretation ("FIN") No. 47,
"Accounting for Conditional Asset Retirement Obligations". FIN No. 47
requires an entity to recognize a liability for a conditional asset
retirement obligation when incurred if the liability can be reasonably
estimated. The Interpretation also clarifies that the term Conditional
Asset Retirement Obligation refers to a legal obligation to perform an
asset retirement activity in which the timing and/or method of settlement
are conditional on a future event that may or may not be within the control
of the entity. FIN No. 47 also clarifies when an entity would have
sufficient information to reasonably estimate the fair value of an asset
retirement obligation. FIN No. 47 has not had a material impact on our
financial condition or results of operations.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections", which changes the requirements for the accounting and
reporting of a change in accounting principle. The statement requires
retrospective application to prior period financial statements of changes
in accounting principle, unless impracticable to do so. It also requires
that a change in the depreciation, amortization, or depletion method for
long-lived non-financial assets be accounted as a change in accounting
estimate, effected by a change in accounting principle. Accounting for
error corrections and accounting estimate changes will still be handled
according to guidance in APB Opinion 20, "Accounting Changes", as carried
forward in this pronouncement. The statement is effective for fiscal years
beginning after December 15, 2005. We do not expect adoption of SFAS No.
154 to have a material impact on the Company's financial condition or
results of operations.
3. Sale of ISP Division
--------------------
Effective May 1, 2002, the Company entered into an agreement to sell
substantially all of the assets of the ISP division to Brand X Networks,
Inc., a California Corporation, for $632,000. The assets have been held and
operated by Brand X Networks, Inc. for its purposes since May 1, 2002, at
which time the Company discontinued its ISP operations. On April 14, 2003,
the Company completed a fifth amendment to the purchase agreement with
Brand X pursuant to which the Company agreed to accept an aggregate payment
of $632,000 for the ISP Division, less credits to Brand X of $112,686 and
interim payments received of $34,859. Of such amount, $200,000 was due to
the Company through the provision of services to the Company from Brand X.
The balance was due at the rate of approximately $5,171 per month, until
completely paid.
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PROTOSOURCE CORPORATION
=======================
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2006
(unaudited)
- --------------------------------------------------------------------------------
3. Sale of ISP Division - Continued
--------------------------------
On January 1, 2004, the sale of the ISP business to Brand X closed. Under
the terms of that agreement a promissory note of $284,455 was executed by
Brand X to be paid in 55 equal monthly installments. This note was
collateralized by a pledge of shares in Brand X. In addition, ProtoSource
was entitled to appoint one person to the board of directors of Brand X for
the duration of the agreement.
In February 2006, still within terms of the purchase agreement, Brand X
notified ProtoSource that it would be unable to make its next payment on
its note payable obligation and could not then specify when the next
payment(s) would be forthcoming. Subsequently, ProtoSource discovered that
Brand X had become insolvent and is unable to meet its obligations to
ProtoSource and, as a consequence, is unable to cure its now default status
on its note payable obligation and, therefore, of the purchase agreement
itself. ProtoSource has assessed the collectibility of the remaining note
receivable balance of $162,582 and its unused services credit balance of
$151,308 and has determined that collection or realization of any portion
of these amounts is highly doubtful and their values should be written down
to $0. As a consequence, the Company recorded a provision for Brand X's
uncollectible note and services credit in the amount of $313,890 in 2005.
Furthermore, in March 2006, ProtoSource agreed to the sale of the Brand X
note to P2i, Inc. ("P2i"), a related party. Under the terms of the sale,
P2i executed a note in favor of ProtoSource which was on the same terms and
conditions as the original note between Brand X and ProtoSource. Brand X
also executed a security agreement in favor of ProtoSource pursuant to
which all of Brand X's assets are pledged to secure the obligations under
the P2i note.
4. Acquisition
-----------
On February 13, 2003, the Company announced an agreement and Plan of Merger
to acquire all of the outstanding capital stock of P2i Newspaper, Inc., a
Delaware corporation ("P2i Newspaper") and a wholly-owned subsidiary of
P2i, Inc., a Pennsylvania corporation ("P2i"), in exchange for the issuance
of up to 19,383,531 shares of ProtoSource common stock and satisfaction of
the existing P2i debt to the Company (the "Agreement"). {As consideration
for the satisfaction of P2i debt, the Company will increase its total
ownership in P2i to 19.8%.}
The 19,383,531 shares will be reduced by the number of shares equal to the
total fees incurred to audit the financial statements of P2i or P2i
Newspaper, divided by $0.50 (the "Adjusted Shares"). The Adjusted Shares
shall be subject to a three-year lock-up, which may be released upon the
stock price and volume reaching established thresholds.
On January 1, 2004, the Company, P2i Newspaper and P2i amended the terms of
the Agreement (the "Amendment"). Pursuant to the terms of the Amendment, in
exchange for all of the issued and outstanding shares of P2i Newspaper, the
Company issued 193,836 shares of series B preferred stock (the "Preferred
Stock"), which shares shall be reduced by the total fees incurred to audit
the financial statements of P2i or P2i Newspaper, divided by $50.
Upon authorization of sufficient shares of common stock, holders of the
Series B Convertible Preferred Stock ("Series B Stock") are entitled to
convert each share of Series B Stock into 100 shares of common stock.
Series B stockholders are not entitled to receive dividends. In a
liquidation, the holders would be treated as if they were owners of the
number of shares of common stock into which the Series B Stock is
convertible.
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PROTOSOURCE CORPORATION
=======================
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2006
(unaudited)
- --------------------------------------------------------------------------------
4. Acquisition - Continued
-----------------------
The acquisition of P2i Newspaper became effective on January 1, 2004, at
which time P2i Newspaper became a wholly-owned subsidiary of the Company.
P2i Newspaper is a leader in the conversion of previously created print
advertising into interactive Web products for newspaper, magazine and mail
order/retail catalog advertising. Clients include newspapers from the
Gannett, Tribune and McClatchy Newspaper groups. The Company is
headquartered in Bethlehem, PA, and has a data conversion facility in Kuala
Lumpur, Malaysia.
The cost was as follows:
Market value of common stock to be issued $416,179
Fair market value of net assets of P2i Newspaper 41,112
--------
Goodwill $375,067
========
Management tests goodwill annually for impairment.
The acquisition of P2i Newspaper was the central component of the
transaction between the Company and P2i; however, in further accordance to
the agreement, as a consideration for the satisfaction of P2i's existing
debt to the Company (i.e., $1,705,062 in notes receivable plus accrued
interest), the Company acquired an additional interest in P2i's new media
business, bringing the Company's total ownership in P2i to 19.8%. However,
despite the increased ownership of P2i, the ownership in P2i is considered
to be of deminimus value and therefore has no classification within the
Company's financial statements.
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PROTOSOURCE CORPORATION
=======================
MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS
(unaudited)
- --------------------------------------------------------------------------------
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS.
Certain statements in this section and elsewhere in this quarterly report on
Form 10-QSB are forward-looking in nature and relate to the Company's plans,
objectives, estimates and goals. Words such as "expects," "anticipates,"
"intends," "plans," "projects," "forecasts," "believes," and "estimates," and
variations of such words and similar expressions, identify such forward-looking
statements. Such statements are made pursuant to the safe harbor provisions of
the private securities litigation reform act of 1995 and speak only as of the
date of this report. The statements are based on current expectations, are
inherently uncertain, are subject to risks and uncertainties and should be
viewed with caution. Actual results and experience may differ materially from
those expressed or implied by the forward-looking statements as a result of many
factors, including, without limitation, those set forth under "Description of
Business" in the Company's most recent Annual Report on Form 10-KSB. The Company
makes no commitment to update any forward-looking statement or to disclose any
facts, events, or circumstances after the date hereof that may affect the
accuracy of any forward-looking statement.
Results of Operations
- ---------------------
Nine Months ended September 30, 2006 vs. Nine Months ended September 30, 2005
Net Revenues - For the nine months ended September 30, 2006 and 2005, net
revenues were $1,910,331 and $1,404,059 respectively. All revenues of the
Company are attributed to the operations of P2i Newspaper, Inc. acquired January
1, 2004. The $506,272 increase in revenues over the previous year is largely
attributable to a sales effort that has focused on media companies within the
newspaper vertical that have a demand for the conversion of large volumes.
Operating Costs and Expenses - For the nine months ended September 30, 2006,
operating costs and expenses totaled $1,746,417 versus $1,383,648 in 2005.
Higher production expenditures necessary to meet the approximately 36% increase
in revenues accounted for most of the increase in operating costs and expenses,
but these cost of revenues, as a percentage of revenues, had risen about 3.5%,
due in part to an expansion of production overhead (capacity) necessary to meet
current and future anticipated rises in production volumes and the establishment
of new service capabilities. Selling, general and administrative expenses
increased $19,587, largely due to higher payroll and payroll related costs and
increased overseas travel. Administrative costs principally consist of the
Company's management office and personnel, professional fees associated with
restructuring and maintenance of the Company, and officers' and directors'
liability insurance costs. In 2006, operating costs and expenses included a
$21,826 loss on disposal of computer equipment.
Interest Expense - Interest expense totaled $262,914 for the nine-month period
ended September 30, 2006 versus $282,557 in the same period in 2005. The
interest expense is a result of the convertible notes obtained during 2002,
2003, and 2004 to fund the operations of the Company and P2i Newspaper, pending
and post merger. A significant component of 2005's interest expense (about
$47,000) includes residual amortization of debt issuance costs incurred during
2004. As there have been no new debt issues since April 2004, the current period
reflects no amortized effect of historical debt issue costs.
- - 14 -
PROTOSOURCE CORPORATION
=======================
MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS
AND RESULTS OF OPERATIONS - CONTINUED
(unaudited)
- --------------------------------------------------------------------------------
Three Months ended September 30, 2006 vs. Three Months ended September 30, 2005
Net revenues - For the three-month periods ended September 30, 2006 and 2005,
net revenues were $641,945 and $475,477, respectively. All revenues of the
Company are attributed to the operations of P2i Newspaper acquired January 1,
2004. The $166,468 increase in revenues over the previous year is largely
attributable to a sales effort that has focused on media companies within the
newspaper vertical that have a demand for the conversion of large volumes.
Operating costs and expenses - For the three months ended September 30, 2006,
operating costs and expenses totaled $597,404 versus $447,675 in 2005. Higher
production expenditures, necessary to meet the approximately 35% increase in
revenues, accounted for most of the increase in operating costs and expenses.
Cost of revenues, as a percentage of revenues, actually increased by about 10%,
due to an expansion of production overhead (capacity) necessary to meet current
and future anticipated rises in production volumes and the establishment of new
service capabilities. This expansion of capacity took place largely during the
second and current quarter. Quarterly selling, general and administrative
expenses did not materially differ from the same quarter in the previous year.
Interest expense - Interest expense totaled $90,591 for the three-month period
ended September 30, 2006 versus $79,027 in the same period in 2005. The interest
expense is the result of the convertible notes obtained during 2002, 2003, and
2004 to fund the operations of the Company and P2i Newspaper, pending and post
merger. Historically, amortization of debt issue costs had been a significant
component of quarterly interest expense, but as there have been no new debt
issues since April 2004, the current quarter and the same quarter last year
reflects no amortized effect of historical debt issue costs.
- - 15 -
PROTOSOURCE CORPORATION
=======================
MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS - CONTINUED
(unaudited)
- --------------------------------------------------------------------------------
Liquidity and Capital Resources
- -------------------------------
We assess liquidity by our ability to generate cash to fund our operations.
Significant factors that affect the management of our liquidity include: current
balances of cash, expected cash flows provided by operations, current levels of
our accounts receivable and accounts payable balances, access to financing
sources and our expected investment in equipment.
The Company experienced a negative cash flow for the nine-month period ending
September 30, 2006 versus a positive cash flow from operating activities for the
nine-month period ending September 30, 2005.
Even though the Company's net loss for the nine-month period ended September 30,
2006 was approximately $96,000, cash flows provided by operations approximated
$230,000. In part, this was due to non-cash charges of approximately $56,000
included in the net loss, consisting primarily of depreciation and amortization
of approximately $34,000 and approximately $22,000 of recorded loss on disposal
of equipment. Additionally, cash flows from operations were enhanced
approximately $270,000 by net positive changes in the Company's working capital
components. Significant components enhancing working capital and available cash,
because they were accrued during the period but unpaid, included approximately
$250,000 of interest arising from the Company's convertible debt obligations,
approximately $25,000 of payroll related obligations, and approximately $25,000
of supplier and service provider obligations. On the other hand, these positive
contributing factors of working capital and available cash were offset during
the period by certain negative components that inhibited net cash provided by
operations. These included an approximately $28,000 of growth in the Company's
accounts receivable and approximately $3,000 of growth in prepaid expenses. The
higher receivables are entirely due to the increased level of revenues, as all
accounts receivable are current. The increase in prepaid expenditures is related
to ordinary operating activities.
During the nine-month period ended September 30, 2006, the Company had negative
cash flows from investing activities of approximately $223,000. This consisted
of approximately $56,000 for acquisitions of new equipment, approximately $6,000
for deposit requirements, approximately $90,000 of advances to directors and
officers, and approximately $72,000 of cash advanced to a related company.
And during the nine-month period ended September 30, 2006, the Company used,
through its financing activities, approximately $19,000 of funds for payments on
capital lease obligations.
As of September 30, 2006, the Company had $28,502 in cash and $610,581 in
accounts receivable and other current assets. Taken together with $3,938,514 of
total current liabilities, this resulted in a negative working capital position
of $3,299,431 at September 30, 2006.
On December 14, 2001, after exploring numerous alternatives, the Company entered
into a term sheet to acquire P2i for 22,768,412 shares of our common stock.
In March 2002, the Company entered into an agreement with AAWC to act as
placement agent for the sale of convertible notes aggregating at least $300,000.
The notes are secured by certain assets of the Company and accrue interest at
10% per annum. P2i has agreed to pay all the costs and obligations incurred with
this financing. The funding was completed during March 2002 and AAWC was paid a
10% commission and a 3% non-accountable expense allowance.
On May 1, 2002, the Company entered into a conditional agreement to sell the
assets of the Fresno-based ISP business to Brand X Networks. Brand X Networks is
a privately held California-based company whose principal shareholders were
former employees of the Company. Additionally, Brand X has assumed financial and
operational responsibility for the ISP business. On April 14, 2003, the Company
completed a fifth amendment to the purchase agreement with Brand X pursuant to
which the Company has agreed to accept an aggregate payment of $632,000 for the
ISP Division, less credits to Brand X of $112,686, and the transaction closed on
January 1, 2004. Of such amount, $200,000 was to be paid through the provision
of services to the Company from Brand X. The balance was to be paid at the rate
of approximately $5,171 per month, until completely paid.
- - 16 -
PROTOSOURCE CORPORATION
=======================
MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS - CONTINUED
(unaudited)
- --------------------------------------------------------------------------------
Liquidity and Capital Resources - Continued
- -------------------------------------------
In February 2006, still within terms of the purchase agreement, Brand X notified
ProtoSource that it would be unable to make its next payment on its note payable
obligation and could not then specify when the next payment(s) would be
forthcoming. Subsequently, ProtoSource discovered that Brand X had become
insolvent and is unable to meet its obligations to ProtoSource and, as a
consequence, is unable to cure its now default status on its note payable
obligation and, therefore, of the purchase agreement itself. ProtoSource has
assessed the collectibility of the remaining note receivable balance of $162,582
and its unused services credit balance of $151,308 and has determined that
collection or realization of any portion of these amounts is highly doubtful and
that their values should be written down to $0. As a consequence of these
subsequent events, the Company recorded a provision for Brand X's uncollectible
note and services credit in the amount of $313,890 in 2005. In March 2006,
ProtoSource agreed to the sale of the Brand X note to P2i, Inc. ("P2i"), a
related party. Under the terms of the sale, P2i executed a note in favor of
ProtoSource which was on the same terms and conditions as the original note
between Brand X and ProtoSource. Brand X also executed a security agreement in
favor of ProtoSource pursuant to which all of Brand X's assets are pledged to
secure the obligations under the P2i note.
In July 2002, the Company executed its merger agreement with P2i. Concurrently,
the Company's CEO, Mr. William Conis, resigned his position as both CEO and
Director. Mr. Peter Wardle, CEO of P2i and a ProtoSource Director, became CEO of
the Company.
On September 17, 2002, the Board of Directors approved a revised term sheet
restructuring the P2i acquisition, and on January 1, 2004, this transaction
closed. Under the new terms, ProtoSource acquired the Newspaper portion of P2i,
Inc.'s business through the acquisition of specific assets which include the
entire newspaper related customer base, technology, intellectual property and
P2i's production company located just south of Kuala Lumpur, Malaysia. In
addition, key P2i employees transitioned with the business. These assets and the
key employees have been transferred to P2i Newspaper, Inc. a wholly-owned
subsidiary of P2i formed specifically for this purpose. The acquisition of P2i
Newspaper, Inc. by ProtoSource has been accounted for by the purchase method of
accounting as a reverse acquisition. For accounting purposes, P2i Newspaper,
Inc. is considered to be the acquirer and ProtoSource is the acquiree.
The number of shares of restricted common stock to be issued to P2i ("P2i,
Inc.") has subsequently been revised to 19,383,531 shares (after conversion of
the preferred stock issued as merger consideration) which will result in an
ownership of approximately 37% by the stockholders of P2i, on a fully diluted
basis assuming conversion of certain bridge loans into common stock, the balance
being held by the current stockholders of ProtoSource. After the acquisition of
P2i Newspaper, the Board of Directors of ProtoSource consists of seven members.
One member has been appointed by the investment banker, AAWC. (This appointment
must be approved by P2i but can't be unreasonably withheld.) Messrs. Wardle and
Butera will be on the Board and they shall appoint the two independent members
plus one other as long as they hold 25% or more of P2i (see below) collectively,
and P2i owns 25% or more of ProtoSource. In the event that P2i's ownership drops
below 25% but is not less than 10%, P2i shall appoint one board member. In the
event that P2i's ownership drops below 10%, P2i shall not have the right to
appoint any board member. ProtoSource and P2i both used the same investment
banker to represent them in the transaction and each will pay the investment
banker a fee based on the value of the transaction using a pre-set formula. The
investment banking fees to be paid are $406,844 by ProtoSource and $413,422 by
P2i. The amounts paid to the investment banker will be paid through the issuance
of common stock, which is restricted for a three-year period, based on an
agreed-upon value of $.50 per share at the time of signing the term sheet, or
813,688 shares for ProtoSource and 826,844 shares for P2i. The shares to be
issued for P2i's investment banking fees will be subtracted from the shares to
be issued to the P2i stockholders for the acquisition. P2i's remaining catalog
and new media business will stay with P2i. However, ProtoSource has increased
its ownership in P2i from the current 2.18% (506,225 shares) to 19.8%. The
consideration paid was the forgiveness of P2i debt to ProtoSource.
- - 17 -
PROTOSOURCE CORPORATION
=======================
MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS - CONTINUED
(unaudited)
- --------------------------------------------------------------------------------
Liquidity and Capital Resources - Continued
- -------------------------------------------
During 2002, the Company entered into an agreement with AAWC to act as a
placement agent for the sale of convertible notes aggregating $1,300,000. The
notes are secured by stock in P2i Newspaper, Inc. and accrue interest at 10% per
annum. The Company pays the cost and obligations of the first $200,000 incurred
with this financing and P2i Newspaper, Inc. has agreed to pay all remaining
costs and obligations. Through December 31, 2003, $1,225,000 in funding had been
completed. AAWC was paid a 10% commission and a 3% non-accountable expense.
Substantially all of the proceeds from these notes have been loaned to P2i
Newspaper, Inc. The loans were in the form of demand notes accruing interest at
8% per annum. These loans, with their related interest receivable, were written
off in 2003.
During May 2003, the Company entered into an agreement with Carl R. Butera for
the sale of a convertible note aggregating $200,000. The note is secured by
stock in P2i Newspaper, Inc. and accrues interest at 10% per annum.
Substantially all of the proceeds from this note have been loaned to P2i
Newspaper, Inc. The loans were in the form of a demand notes accruing interest
at 8% per annum. These loans, with their related interest receivable, were
written off in 2003.
During the twelve-month period ended December 31, 2003, the Company entered into
certain agreements with AAWC to act as a placement agent for the sale of
convertible notes aggregating $700,000. The notes are secured by stock in P2i
and accrue interest at 10% per annum. P2i has agreed to pay the related costs
and obligations. Through December 31, 2003, $600,000 in funding had been
completed; an additional $100,000 was completed during January 2004. AAWC was
paid a 10% commission and a 3% non-accountable expense. Substantially all of the
proceeds from these notes have been loaned to P2i Newspaper, Inc. The loans were
in the form of demand notes accruing interest at 8% per annum. These loans, with
their related interest receivable, were written off in 2003.
During 2004, the Company entered into certain agreements with AAWC to act as a
placement agent for the sale of convertible notes aggregating $500,000, of which
$300,000 was raised during the first and second quarters of 2004. These notes
accrue interest at 10% per annum. AAWC was paid a 10% commission and a 3%
non-accountable expense. These notes and all other notes are secured by the
assets of ProtoSource and P2i Newspaper.
On October 15, 2005, the Company entered into a 24-month term capital lease
agreement with Bankers Capital for the purchase of computer and computer related
items valued at $27,767 with monthly lease payments of $1,596 each. The lease
term expires September 14, 2007 and the residual maturity date is October 15,
2007 with a $1.00 purchase option. $3,487 was paid to Bankers Capital at the
start of the lease to cover the first payment, one payment held for a security
deposit, and for UCC filing and documentation fees. Company officers, Peter A.
Wardle and Thomas C. Butera, are personal Guarantors of this agreement.
On July 15, 2006, the Company entered into a 24-month term capital lease
agreement with Bankers Capital for the purchase of computer and computer related
items valued at $26,827 with monthly lease payments of $1,521 each. The lease
term expires June 14, 2008 and the residual maturity date is July 15, 2008 with
a $1.00 purchase option. $3,438 was paid to Bankers Capital at the start of the
lease to cover the first payment, one payment held for a security deposit, and
for UCC filing and documentation fees. Company officers, Peter A. Wardle and
Thomas C. Butera, are personal Guarantors of this agreement.
- - 18 -
PROTOSOURCE CORPORATION
=======================
MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS - CONTINUED
(unaudited)
- --------------------------------------------------------------------------------
Critical Accounting Policies and Estimates
- ------------------------------------------
Management's discussion and analysis of its financial position and results of
operations are based upon the Company's condensed consolidated financial
statements, which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of these financial
statements requires management to make estimates and assumptions that affect the
reported amounts of assets, liabilities, revenue and expenses and related
disclosure of contingent assets and liabilities. The significant accounting
policies which we believe are the most critical to aid in fully understanding
and evaluating our reported financial results include the following:
In accordance with SFAS No. 109, "Accounting for Income Taxes", the Company
maintains a valuation allowance of $5,560,000 as of September 30, 2006 on
deferred tax assets relating to its net operating losses which the Company has
not determined to be more likely than not realizable.
In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets",
goodwill is not amortized, rather, management tests goodwill annually for
impairment in the fourth quarter.
The Company considers its accounts receivable to be fully collectible;
accordingly, the Company has a $0 allowance for doubtful accounts. The Company
considers the balances of its note receivable of $162,582 and its unused
services credit of $151,308 as uncollectible or unrealizable; accordingly, a
$313,890 allowance was recorded in 2005.
Item 3. CONTROLS AND PROCEDURES.
Evaluation of disclosure controls and procedures.
An evaluation was performed under the supervision and with the participation of
our management, including the chief executive officer, or CEO, who is also the
acting chief financial officer, or CFO, of the effectiveness of the design and
operation of our disclosure procedures. Based on management's evaluation as of
as of the end of the period covered by this Report, our principal executive
officer and chief financial officer has concluded that our disclosure controls
and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities
Exchange Act of 1934, as amended (the "Exchange Act") were sufficiently
effective to ensure that the information required to be disclosed by us in the
reports that we file under the Exchange Act is gathered, analyzed and disclosed
with adequate timeliness, accuracy and completeness.
Changes in internal controls.
There have been no significant changes in our internal controls or in other
factors that could significantly affect these controls subsequent to the date of
the evaluation referred to above, nor were there any significant deficiencies or
material weaknesses in our internal controls. Accordingly, no corrective actions
were required or undertaken except as disclosed.
- - 19 -
PROTOSOURCE CORPORATION
=======================
OTHER INFORMATION
(unaudited)
- --------------------------------------------------------------------------------
PART II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS.
From time to time the Company is subject to litigation incidental to its
business. The Company is not currently a party to any material legal proceedings
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
None.
Item 3. DEFAULTS UPON SENIOR SECURITIES.
Not applicable.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
Item 5. OTHER INFORMATION.
Item 6. EXHIBITS.
Exhibits.
The following exhibits are filed with this report:
Exhibit 31.1 - Certification of CEO and CFO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
Exhibit 32.1 - Certification of CEO and CFO pursuant to 18 U.S.C. Section 1350
- - 20 -
PROTOSOURCE CORPORATION
=======================
SIGNATURE
- --------------------------------------------------------------------------------
In accordance with the requirements of the Exchange Act, the registrant has
caused this report to be signed on its behalf by the undersigned thereunto duly
authorized.
PROTOSOURCE CORPORATION
/s/ Peter Wardle
----------------
Peter Wardle,
Chief Executive Officer/
Chief Financial Officer
Date: November 15, 2006
- - 21 -