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U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
(Mark One)
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 for the quarterly period ended June 30,
2005. (Second quarter of fiscal 2005)
OR
|_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE
ACT For the transition period from _____________ to __________
Commission File No. 0-24073
DIGITAL FUSION, INC.
(Exact Name of Small Business Issuer as Specified in Its Charter)
Delaware 13-3817344
(State or Other Jurisdiction (I.R.S. Employer I.D. No.)
of Incorporation or Organization)
4940-A Corporate Drive
Huntsville, AL 35805
(Address of Principal Executive Offices)
(256) 837-2620
(Issuer's Telephone Number, Including Area Code)
Check whether the issuer: (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days. Yes |X| No
|_|
As of August 1, 2005, 11,049,052 shares of the issuer's common stock, par
value $.01 per share, were outstanding.
Transitional Small Business Disclosure Format (check one): Yes |_| No |X|
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DIGITAL FUSION, INC.
INDEX
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PART I. FINANCIAL INFORMATION Page No.
--------
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of June 30, 2005 (unaudited) and December
31, 2004........................................................................... 1
Condensed Consolidated Statements of Operations for the three and six months ended
June 30, 2005 and 2004 (unaudited)................................................. 2
Condensed Consolidated Statements of Cash Flows for the six months ended June 30,
2005 and 2004 (unaudited) 3
Notes to Condensed Consolidated Financial Statements 4
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
10
Item 3. Controls and Procedures............................................................. 16
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................................... 17
Item 2. Changes in Securities.............................................................. 17
Item 3. Defaults Upon Senior Securities.................................................... 17
Item 4. Submission of Matters to a Vote of Security Holders................................ 17
Item 5. Other Information.................................................................. 18
Item 6. Exhibits........................................................................... 18
SIGNATURES.................................................................................. 19
Section 302 Certification by Chief Executive Officer
Section 906 Certification by Chief Executive Officer
PART I FINANCIAL INFORMATION
Item 1. Financial Statements.
DIGITAL FUSION, INC.
Condensed Consolidated Balance Sheets
(In thousands)
June 30, 2005 December 31,
(Unaudited) 2004
------------ -----------
ASSETS
Current Assets:
Cash and cash equivalents $ 1 $ 252
Accounts receivable (net of allowance for doubtful accounts of $29 and $54 for 2005 and 2004,
respectively) 2,923 1,050
Unbilled receivables 625 -
Prepaid expenses and other current assets 90 27
------------ --------
Total current assets 3,639 1,329
Property and equipment, net of accumulated depreciation of $1,029 for 2005 and $952 for 2004 496 417
Prepaid acquisition costs and acquisition deposit - 285
Goodwill 5,919 3,347
Purchased intangible assets, net 1,843 -
Other assets 16 13
------------ --------
Total assets $ 11,913 $ 5,391
============ ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Current maturities of long-term debt $ 1,071 $ 647
Accounts payable 914 609
Deferred revenue 373 21
Accrued compensation and related expenses 774 97
Other current liabilities 107 266
------------ --------
Total current liabilities 3,239 1,640
Long-term debt, less current maturities 2,877 81
Pension obligation 302 302
------------ --------
Total liabilities 6,418 2,023
------------ --------
Stockholders' Equity:
Preferred Stock - $.01 par value; authorized
1,000 shares, no shares issued and outstanding - -
Common Stock - $.01 par value; authorized
30,000 shares; 11,045 and 9,721 shares issued
and outstanding at June 30, 2005 and
December 31,2004,respectively 110 97
Additional paid in capital 44,057 42,050
Accumulated deficit (38,672) (38,779)
------------ --------
Total stockholders' equity 5,495 3,368
------------ --------
Total liabilities and stockholders' equity $ 11,913 $ 5,391
============ ========
See Accompanying Notes to Condensed Consolidated Financial Statements.
1
DIGITAL FUSION, INC.
Condensed Consolidated Statements of Operations
For the three and six months ended June 30, 2005 and 2004
(Unaudited)
(In thousands, except per share amounts)
Three months Six months
ended ended
June 30, June 30,
------------- -------------
2005 2004 2005 2004
------ ------ ------ ------
Revenues
Services and fees $3,587 $1,023 $7,082 $2,176
Reimbursed costs 635 142 1,144 270
Product 327 471 764 676
------ ------ ------ ------
Total Revenues 4,549 1,636 8,990 3,122
------ ------ ------ ------
Cost of services and goods sold
Services 2,779 851 5,442 1,682
Reimbursed costs 600 108 1,076 220
Product 309 444 731 633
Total cost of services and goods sold 3,688 1,403 7,249 2,535
------ ------ ------ ------
Gross profit 861 233 1,741 587
Selling, general and administrative 609 427 1,247 837
------ ------ ------ ------
Operating income (loss) 252 (194) 494 (250)
Other income (expenses):
Interest expense, net (36) (39) (83) (73)
Other income 20 - 20 -
Amortization of intangible assets (100) - (100) -
Amortization of discount on debt and
intrinsic value of convertible debt (122) - (224) -
------ ------ ------ ------
Total other expenses (238) (39) (387) (73)
------ ------ ------ ------
Net income (loss) before income taxes 14 (233) 107 (323)
Income tax benefit - - - -
------ ------ ------ ------
Net income (loss) $ 14 $ (233)$ 107 $ (323)
====== ====== ====== ======
Basic earnings (loss) per share $ 0.00 $(0.03)$ 0.01 $(0.04)
======= ====== ======= ======
Basic weighted average common shares outstanding 10,873 7,985 10,661 7,985
======= ====== ======= ======
Dilute earnings (loss) per share $ 0.00 $(0.03)$ 0.01 $(0.04)
======= ====== ======= ======
Diluted weighted average common shares
outstanding 12,938 7,985 12,764 7,985
======= ====== ======= ======
See Accompanying Notes to Condensed Consolidated Statements.
2
DIGITAL FUSION, INC.
Condensed Consolidated Statements of Cash Flows
For the six months ended June 30, 2005 and 2004
(Unaudited)
(In thousands)
2005 2004
------- -----
Cash flows provided by (used in) operating activities:
Net income (loss) $ 107 $(323)
Adjustments to reconcile net loss to net cash used in
operating activities, net of effect of acquisition:
Depreciation and amortization 77 36
Amortization of intangible assets 100 -
Amortization of beneficial interest 161 -
Amortization of discount on debt 63 -
Changes in assets and liabilities (217) (131)
------- -----
Net cash provided by (used in) operating activities 291 (418)
------- -----
Cash flows used in investing activities:
Capital expenditures - property and equipment (98) (4)
Acquisition of Summit (1,118) -
------- -----
Net cash used in investing activities (1,216) (4)
------- -----
Cash flows provided by (used in) financing activities:
Proceeds from exercise of options and warrants 676 -
Repayments of notes payable (423) (6)
Net proceeds from equity sale 453
Net proceeds from line of credit 421 -
------- -----
Net cash provided by financing activities 674 447
------- -----
Net increase (decrease in) cash and cash equivalents (251) 25
Cash and cash equivalents, beginning of periods 252 419
------- -----
Cash and cash equivalents, end of periods $ 1 $ 444
======= =====
See Accompanying Notes to Condensed Consolidated Financial Statements.
3
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation
The condensed consolidated interim financial statements of Digital Fusion,
Inc. ("Digital Fusion", "DFI", or the "Company") have been prepared by the
Company, without audit, pursuant to the rules and regulations of the Securities
and Exchange Commission with respect to Form 10-QSB. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to such rules and regulations, although the Company believes
that the disclosures made herein are adequate to make the information contained
herein not misleading. These condensed consolidated interim financial statements
should be read in conjunction with the Company's audited financial statements
for the year ended December 31, 2004 and the notes thereto included in the
Company's Annual Report on Form 10-KSB. In the Company's opinion, all
adjustments (consisting only of normal recurring) necessary for a fair
presentation of the information shown herein have been included.
The results of operations for the three and six months ended June 30, 2005
are not necessarily indicative of the results of operations expected for the
full year.
2. Earnings per Share and Stock-Based Compensation
The Company accounts for stock-based compensation issued to employees under
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. Under the intrinsic value based method,
compensation cost is measured on the date of grant as the excess of the quoted
market price of the underlying stock over the exercise price. Such compensation
amounts are amortized over the vesting periods of the options. During the three
months ended June 30, 2005, 222,500 stock options were granted to employees and
directors. During the six months ended June 30, 2005, 222,500 stock options were
granted to employees and directors.
The following table illustrates the effect on net loss and loss per share
as if the fair value based method of accounting had been applied to stock-based
employee compensation, as required by SFAS No. 123, "Accounting for Stock-Based
Compensation" and SFAS 148 "Accounting for Stock-Based Compensation - transition
and disclosure", an amendment of SFAS No. 123 for the three and six months ended
June 30, 2005 and 2004, respectively. (in thousands, except per share data):
4
Three Months Ended June 30, Six Months Ended June 30,
2005 2004 2005 2004
---- ---- ---- ----
Net income (loss), as reported $ (14) $ (233) $ 107 $ (323)
Less: stock-based compensation expense, net of tax $ (210) $ (52) $ (242) $ (75)
-------------- ------------- -------------- -------------
Net loss, pro forma (196) (285) (135) (398)
============== ============= ============== =============
Basic net income (loss) per share :
As reported $ 0.00 $ (0.03) $ 0.01 $ (0.04)
============== ============= ============== =============
Pro forma $ (0.01) $ (0.04) $ (0.00) $ (0.05)
============== ============= ============== =============
Diluted net income (loss) per share:
As reported $ 0.00 $ (0.03) $ 0.01 $ (0.04)
============== ============= ============== =============
Pro forma $ (0.01) $ (0.04) $ (0.00) $ (0.05)
============== ============= ============== =============
The pro forma amounts reflected above are not representative of the effects
on reported net income in future years because, in general, the options granted
typically do not vest for several years and additional awards are made each
year. The fair value of each option grant is estimated on the grant date using
the Black-Scholes option-pricing model with the following weighted-average
assumptions:
2005 2004
------------- -------------
Risk-free interest rate 3.97% 4.43%
Dividend yield 0% 0%
Expected life - years 10 10
Volatility 57% 59%
5
3. Earnings (Loss) Per Share Data
Common stock equivalents in the three and six months ended June 30, 2004,
were anti-dilutive due to the net losses sustained by the Company during this
period. Therefore, the diluted weighted average common stock shares outstanding
in this period are the same as the basic weighted average common stock shares
outstanding.
Earnings per common share are computed in accordance with SFAS No. 128,
"Earnings Per Share," which requires companies to present basic earnings per
share and diluted earnings per share. Basic earnings per share are computed by
dividing net income by the weighted average number of shares of common stock
outstanding during the year. Diluted earnings per common share are computed by
dividing net income by the weighted average number of shares of common stock
outstanding and dilutive options outstanding during the year. The weighted
average number of shares and the diluted weighted average number of shares was
7,984,904 and 8,636,445 for the three and six months ended June 30, 2004,
respectively.
4. Income Taxes
The income tax expense for the Company's income from operations generated
during the six months of 2005 was offset by a reduction in the valuation
allowance established against deferred tax assets arising from prior periods.
For the six month period ended June 30, 2004, the Company did not recognize an
income tax benefit for its operating losses generated in that period based on
uncertainties concerning its ability to generate taxable income in future
periods. The tax benefit for the three and six month period ended June 30, 2005
is offset by a valuation allowance established against deferred tax assets
arising from operating losses and other temporary differences, the realization
of which could not be considered more likely than not. In future periods, tax
benefits and related deferred tax assets will be recognized when management
considers realization of such amounts to be more likely than not.
5. Debt
During April 2005, the Company paid a note holder $216,996 that was
comprised of $183,946 of principal and the remaining amount was accrued interest
on his note. Additionally, in April the Company refinanced two notes held by the
Chief Executive Officer by executing a $374,304 convertible note. The
convertible note bears an annual interest rate of prime and interest is payable
monthly. The CEO can convert the note into the Company's common stock at a
conversion price of $2.43 per share. The note matures on April 29, 2007.
On May 26, 2005, Digital Fusion amended its secured revolving line of
credit agreement with a local bank. The Amendment (i) extended the maturity date
to May 20, 2006, (ii) stated the rate of interest at prime, payable monthly and
(iii) secured the line of credit by the Company's receivables and certain
guarantees. The line of credit is not to exceed the lower of 90% of eligible
accounts receivable or $3.5 million.
On July 1, 2005, the Company paid an installment payment as required by the
Summit acquisition of $905,047 that was comprised of $877,195 of principal and
the remaining amount was accrued interest. See Note 6 below for a discussion of
the debt acquired during the first quarter of 2005 from the acquisition of
Summit Research Corporation.
6
6. Commitments
Government Contracting
Payments to the Company on cost-plus-fee contracts are provisional and are
subject to adjustment upon audit by the Defense Contract Audit Agency (DCAA). In
the opinion of management, audit adjustments that may result from DCAA audits
are not expected to have a material effect on the Company's financial position,
results of operations, or cash flows.
7. Summit Acquisition
On January 3, 2005, the Company closed on its acquisition of Summit
Research Corporation ("Summit"). To purchase all of the outstanding capital
stock of Summit, the Company (a) paid $1.6 million in cash (b) issued 575,000
shares of its common stock (c) entered into a six-month note for $898,692 (6%
annual interest) and (d) executed a convertible promissory note for $2.7
million. The note holder may convert the principal portion of the convertible
note into the Company's common stock at a conversion price of $2.25 per share.
In the event the entire convertible note is converted, the note holder will
receive a total of 1.2 million shares of the Company's common stock. The annual
interest rate is 5%; however, no interest shall accrue for the first six months
and during any calendar month in which the average closing price of the publicly
traded Company's common stock is greater than $2.80 per share. The Company
recorded imputed interest of $228,000. The estimates used to determine the
imputed interest will be reviewed each quarter and adjusted as needed. The
imputed interest amount of $228,000 will be amortized to interest expense over a
four year period. The Company also estimated the intrinsic value of the embedded
beneficial conversion options of the $2.7 million note at $769,000. The $769,000
will be amortized to interest expense over the life of the note.
In conjunction with this acquisition, on January 3, 2005, the Company
entered into employment agreements with two individuals with Summit. The annual
salaries for these two individuals total $310,000 per year for two years or when
the convertible note is paid off whichever is later.
The Company included the results of Summit in its financial statements
beginning January 1, 2005. The following table summarizes the estimated fair
values of the assets acquired and liabilities assumed. During the three months
ended June 30, 2005, the Company finished its evaluation of the intangibles
purchased and finalized the purchase price allocation. The $2.6 million of
intangible assets represents $2.2 million allocated to customer base intangibles
and $367,000 allocated to employment and non-compete agreements.
(in thousands)
Accounts receivable $ 2,354
Fixed assets 57
Other assets 313
Goodwill 1,921
Intangible assets 2,594
--------------------------
Total assets acquired 7,236
--------------------------
Notes payable (300)
Accounts payable and accrued liabilities (1,225)
--------------------------
Total liabilities assumed (1,525)
--------------------------
Total purchase price $ 5,714
==========================
7
8. Unaudited Pro Forma Financial information for Acquisition
The following unaudited pro forma financial information presents the
combined results of operations of the Company as if the Summit acquisition had
occurred on January 1, 2004. The unaudited pro forma financial information is
not intended to represent or be indicative of the consolidated results of
operations of the Company that would have been reported had the acquisition been
completed as of the dates presented, and should not be taken as representative
of the future consolidated results of operations of the Company. Summarized
unaudited pro forma results were as follows for the three and six months ended
June 30, 2004:
(in thousands)
Three months ended June 30, Six months ended June 30,
2004 2004
Revenues $ 3,886 $ 7,276
Net (loss) income $ (10) $ 30
Basic earnings per share $ (0.00) $ 0.00
Weighted average common stock shares
outstanding 8,560 8,560
9. Stockholders' Equity
A summary of the changes in stockholders' equity for the six months ended
June 30, 2005 is as follows:
Stockholders' Equity
--------------------
Balance, December 31, 2004 $3,368
Net income 107
Shares issued in Summit purchase 575
Exercise of stock options and warrants 676
Beneficial interest Summit acquisition 769
Balance, June 30, 2005 $5,495
======
On January 3, 2005, as part of the acquisition of Summit Research
Corporation, the Company issued 575,000 shares of its common stock. Effective
March 17, 2005, Madison Run, LLC exercised warrants to purchase 354,054 shares
of the Company's common stock. The Company received $333,108 from the exercise
of these warrants. On June 6, 2005, Madison Run, LLC exercised warrants to
purchase 212,839 shares of the Company's common stock. The Company received
$200,069 from the exercise of these warrants.
8
In addition to the Madison Run, LLC and Summit acquisition transactions
above, the Company issued 181,915 shares of common stock to fulfill stock option
and stock warrant exercises during the six months ended June 30, 2005. The stock
options and stock warrants had exercise prices ranging from $0.33 to $1.01. The
Company received proceeds totaling $143,210 from the exercise of these stock
options and stock warrants during the six months ended June 30, 2005.
The Board of Directors has approved an amendment to the Company's Restated
Certificate of Incorporation to increase the number of authorized shares of
common stock the Company is authorized to issue from Sixteen Million
(16,000,000) shares to Thirty Million (30,000,000) shares. The Company's
authorized Preferred Stock of One Million (1,000,000) shares will remain
unchanged. At the Company's Annual Meeting of stockholders held on June 28,
2005, stockholders approved the proposal to amend the Restated Certificate of
Incorporation to increase the number of authorized shares of common stock.
10. Stock Option Plans
At the Company's Annual Meeting of stockholders held on June 28, 2005, the
Digital Fusion, Inc. 2005 Stock Option Plan (the "2005 Stock Option Plan") was
approved. The 2005 Stock Option Plan, an incentive and non-qualified stock
option plan which authorizes the issuance of up to 750,000 shares of our common
stock was approved by the Board of Directors subject to stockholder approval.
The 750,000 shares of common stock authorized will be used to grant
non-qualified stock options to our employees, directors, officers and
consultants and incentive stock options to our employees. The Company does not
have any current definitive plans for the grant of options.
With respect to incentive stock options, the 2005 Stock Option Plan
provides that the exercise price of each such option must be at least equal to
100% of the fair market value of our common stock on the date of grant (110% in
the case of stockholders who, at the time the option is granted, own more than
10% of the outstanding common stock), and requires that all such options have an
expiration date not later than that date which is one day before the tenth
anniversary of the date of the grant (or the fifth anniversary of the date of
grant in the case of 10% stockholders). Pursuant to the provisions of the 2005
Stock Option Plan, the aggregate fair market value, determined as of the date(s)
of grant, for which incentive stock options are first exercisable by an option
holder during any one calendar year cannot exceed $100,000.
With respect to non-qualified stock options, the 2005 Stock Option Plan
requires that the exercise price of all such options be at least equal to 100%
of the fair market value of our common stock on the date such option is granted
and requires that all such options have an expiration date not later than that
date which is one day before the tenth anniversary of the date of the grant of
such option.
10. Reclassifications
The Company has reclassed certain amounts for the three and six months
ending June 30, 2004 to conform to the 2005 presentation on its Condensed
Consolidated Statements of Operation.
9
11. Subsequent Events
On July 1, 2005, the Company paid an installment payment as required by the
Summit acquisition of $905,047 that was $877,195 in principal and the remaining
amount in accrued interest.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
This Quarterly Report on Form 10-QSB contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). In addition, from time to time, the Company or its representatives have
made or may make other forward-looking statements orally or in writing. Such
statements may include, without being limited to, statements concerning
anticipated financial performance, future revenues or earnings, business
prospects, projected ventures, new products, anticipated market performance, and
similar matters. The words "plan," "budget, "intend," "anticipate," "project,"
"estimate," "expect," "may," "might," "believe," "potential," "could," "should,"
"would" and similar statements are intended to be among the statements that are
forward-looking statements. The Private Securities Litigation Reform Act of 1995
provides a safe harbor for forward-looking statements. In order to comply with
the terms of the safe harbor, readers are cautioned that, because such
statements reflect the reality of risk and uncertainty that is inherent in doing
business, actual results may differ materially from those expressed or implied
by such forward-looking statements. These risks and uncertainties, many of which
are beyond the Company's control, include, but are not limited to, those set
forth in the Company's Form 10-KSB for 2004 in the Management's Discussion and
Analysis of Financial Condition and Results of Operations under the heading
"Certain Factors Which May Affect the Company's Future Performance" which are
incorporated herein by reference. Readers are cautioned not to place undue
reliance on these forward-looking statements, which are made as of the date of
this report. Except as otherwise required to be disclosed in periodic reports
required to be filed by companies registered under the Exchange Act by the rules
of the SEC, the Company has no duty and undertakes no obligation to update such
statements.
Overview
Digital Fusion is an information technology and engineering services
company that helps its customers make the most of technology to meet their
business needs. The Company's IT Services provides solutions to both government
and commercial customers, focused in the following areas: Business process
Automation, Application Development and Data Management, Application Security,
Web Portals and Digital Dashboards, System Integration and IT Support. Digital
Fusion's engineering services supports a variety of customers with state-of-the
art solutions that include Computational Aerodynamics/CFD, Optical Systems
Design, Development and Test, Thermo/structural Dynamics, Models and
Simulations, and Ground/Flight Planning, Execution, and Data Analysis. Based in
Huntsville, Alabama, Digital Fusion also has an office in New Jersey and a
satellite office in Florida.
Revenues are derived primarily from fees earned in connection with the
performance of services provided to customers. The Company typically invoices on
a time and materials basis. The majority of costs are associated with personnel.
Attracting and retaining billable employees is vital for the Company to move
forward. Quarterly operating results are affected by the number of billable days
in the quarter, holiday seasons, and vacations. Demand for the Company's
services has historically been lower during the fourth quarter because of
holidays and vacations. Currently, the majority of the Track-It! product sales
are to governmental entities where margins are lower. During the third quarter
2004, Digital Fusion began selling the SPI Dynamics Information Assurance
product line WebInspect. Digital Fusion is a Value Added Reseller (VAR) for SPI
Dynamics. WebInspect audits web based applications and determines security
vulnerabilities. Digital Fusion markets these products along with remediation
services to commercial and government customers.
10
With the addition of engineering services during the third quarter of 2004
and the acquisition of Summit on January 3, 2005, Digital Fusion greatly
expanded its services offerings and past performance with governmental customers
and federal prime contracts. Engineering services include the design,
development and integration of advanced sensing systems as well as aerodynamic
analysis and thermal-structural analysis. The engineering services provided by
the Summit acquisition include modeling & simulation, hardware-in-the-loop
testing, mechanical design & prototype fabrication, information technology and
information management systems, program analysis, and associated technology
transfer into production automation processes. These new services give the
Company the ability to capitalize on the increased spending by the governmental
sector due to increased military and homeland security spending.
With the addition of engineering services and the acquisition of Summit,
the Company believes it has taken the necessary steps to attain positive cash
flow from continuing operations during 2005. The Company will continue to focus
on consistent collections of accounts receivable and continued improvements in
its operational performance. Company management believes that, as a result of
these actions and assuming it can grow its client base in the private and
federal sectors, it currently has sufficient cash to meet its funding
requirements over the next year, although the Company has experienced negative
cash flows from operations and incurred large net losses in the past.
Results of Operations
THREE AND SIX MONTHS ENDED JUNE 30, 2005 COMPARED TO THE THREE AND SIX
MONTHS ENDED JUNE 30, 2004
REVENUES. Service revenue increased approximately $2.6 million from $1.0
million for the three months ended June 30, 2004 to $3.6 million for the three
months ended June 30, 2005. Service revenue increased approximately $4.9 million
from $2.2 million for the six months ended June 30, 2004 to $7.1 million for the
six months ended June 30, 2005. Reimbursed costs revenue increased approximately
$493,000 from $142,000 for the three months ended June 30, 2004 to $635,000 for
the three months ended June 30, 2005. Reimbursed costs revenue increased
approximately $874,000 from $270,000 for the six months ended June 30, 2004 to
$1,144,000 for the six months ended June 30, 2005.
The increase in service revenue and reimbursed costs revenue was primarily
related to the Summit acquisition and growth in the engineering services. The
Summit acquisition accounted for $2.2 million and $4.4 million of increased
revenue, and the newly formed engineering services division accounted for
$848,000 and $1.9 of revenues during the three and six months ended June 30,
2005, respectively. The increases in revenue related to the Summit acquisition
and growth in the engineering services, are partially offset by decreases in IT
services revenue. The Company expects its revenues to increase during the
remainder of 2005 as compared to 2004 due to the addition of engineering
services and the Summit acquisition.
11
Product revenues decreased $144,000 from $471,000 in the three months ended
June 30, 2004 to $327,000 in the three months ended June 30, 2005. Product
revenues increased $88,000 from $676,000 in the six months ended June 30, 2004
to $764,000 in the six months ended June 30, 2005. During the third quarter of
2004, Digital Fusion began selling the SPI Dynamics Information Assurance
product line WebInspect and is the sole source through which Intuit can sell to
governmental entities. As the relationship between DFI and Intuit has
solidified, Intuit developed its own federal team that concentrates on
governmental agencies exclusively.
COST OF SERVICES AND GOODS SOLD. Cost of services includes labor, or the
salaries and wages of our employees, plus fringe benefit; and other direct
costs. Cost of services increased by $1,928,000 to $2,779,000 for the three
months ended June 30, 2005. Cost of services increased by $3,760,000 to
$5,442,000 for the six months ended June 30, 2005. The increase in cost of
services for the three and six months ended June 30, 2005 compared to the three
and six months ended June 30, 2004 is due to the increase in revenues as a
result of the Summit acquisition and the addition of engineering services.
Reimbursed costs consist primarily of third-party materials, such as
hardware and software that we purchase for customer solutions resold to
customers and also include the costs of subcontracted labor and travel related
expenses that are reimbursed. The increase in the reimbursed costs from $108,000
for the three months ended June 30, 2004 to $600,000 for the three months ended
June 30, 2005 and the increase in the reimbursed costs from $220,000 for the six
months ended June 30, 2004 to $1,076,000 for the six months ended June 30, 2005
is primarily due to the materials that are resold to the Summit customers.
Product cost of goods sold decreased by $135,000 to $309,000 for the three
months ended June 30, 2005 and increased by $98,000 to $731,000 for the six
months ended June 30, 2005. The changes in cost of goods sold are primarily
related to the changes in sales of the Intuit product Track-It! and the newly
introduced SPI Dynamics Information Assurance product line WebInspect.
GROSS PROFIT. Gross profit for services during the three months ended June
30, 2005 is $808,000 or 22.5% of services revenues as compared to $172,000, or
16.8% of services revenues for the three months ended June 30, 2004. Gross
profit for services during the six months ended June 30, 2005 is $1,640,000 or
23.2% of services revenues as compared to $494,000, or 22.7% of services
revenues for the six months ended June 30, 2004. The increase in services gross
profit as a percent of services revenues is primarily due to a change in
business mix resulting from the Summit acquisition and the addition of
engineering services.
Gross profit for the reimbursed costs during the three months ended June
30, 2005 is $35,000 or 5.5% of reimbursed costs revenue as compared to $34,000
and 23.9% of reimbursed costs revenue for the three months ended June 30, 2004.
Gross profit for the reimbursed costs during the six months ended June 30, 2005
is $68,000 or 5.9% of reimbursed costs revenue as compared to $50,000 or 18.5%
of reimbursed costs revenue for the six months ended June 30, 2004. The decrease
in gross profit as a percentage of reimbursed costs revenue is primarily related
to the lower mark-up on material purchases for Summit and engineering services
customers. Generally, there is very low margin on this type of revenue.
Gross profit for product was $18,000 or 5.5% for the three months ended
June 30, 2005 and $27,000 or 5.7% for the three months ended June 30, 2004.
Gross profit for product was $33,000 or 4.3% for the six months ended June 30,
2005 and $43,000 or 6.3% for the six months ended June 30, 2004. The decrease in
profit margin on product sales is primarily attributable to an increase in
pricing pressure.
12
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
("SG&A") expenses consist primarily of salaries and expenses associated with
marketing, accounting, finance, sales, and administrative personnel, as well as
professional fees and other corporate costs related to the administration of the
company. SG&A expenses increased $182,000 for the three month ended June 30,
2005 compared to the three month ended June 30, 2004 and increased $410,000 for
the six month ended June 30, 2005 compared to the six month ended June 30, 2004.
The increase in SG&A is primarily related to the addition of engineering
services and the acquisition of Summit, partially offset by a $20,000 reduction
in our allowance for doubtful accounts. SG&A as a percent of revenue was 13.4%
and 26.1% for the three months ending June 30, 2005 and 2004, respectively. SG&A
as a percent of revenue was 13.9% and 26.8% for the six months ending June 30,
2005 and 2004, respectively. The Company expects its SG&A will continue to
decrease as a percent of revenue for the remainder of 2005; however, the Company
expects its SG&A actual dollars to continue to increase for the remainder of
2005 compared to the same periods in 2004 due to the addition of engineering
services and the acquisition of Summit.
INTEREST EXPENSE, NET. Interest expense decreased from $39,000 in the three
months ended June 30, 2004 to $36,000 for the three months ended June 30, 2005
and increased from $73,000 in the six months ended June 30, 2004 to $83,000 for
the six months ended June 30, 2005. The charges are primarily related to the
additional debt issued to the former Summit shareholder for the acquisition of
Summit, partially offset by strong cash collections that reduced borrowings in
the three months ended June 30, 2005.
OTHER INCOME. The $20,000 of other income recorded in the three months
ended June 30, 2005 is related to the reversal of deferred revenue recorded in
prior years for obligations that no longer exist and for services the company no
longer provides.
AMORTIZATION OF INTANGIBLE ASSETS. The $100,000 amortization of intangible
assets is related to the Summit acquisition. The Company allocated $1,668,833 to
the customer base intangible assets and allocated $274,677 to employment
agreements acquired in the Summit acquisition. The Company is amortizing the
customer base and employment agreements over five and four years, respectively.
There was no such expense during 2004.
AMORTIZATION OF DISCOUNT ON DEBT AND INTRINSIC VALUE OF CONVERTIBLE DEBT.
The $122,000 and $224,000 amortization of debt discount and intrinsic value of
the convertible debt in the three and six months ended June 30, 2005 are related
to the convertible debt issued to the former Summit shareholder. The Company
expects this expense to continue throughout 2005. There was no such expense
during 2004.
INCOME TAX BENEFIT. The income tax expense for the Company's income from
operations generated during the six months ended June 30, 2005 was offset by a
reduction in the valuation allowance established against deferred tax assets
arising from prior periods. The Company has not recognized an income tax benefit
for its operating losses generated in the three months and six months ended June
30, 2004 based on uncertainties concerning its ability to generate taxable
income in future periods. The tax benefit for the three and six months ended
June 30, 2004 is offset by a valuation allowance established against deferred
tax assets arising from operating losses and other temporary differences, the
realization of which could not be considered more likely than not. In future
periods, tax benefits and related deferred tax assets will be recognized when
management considers realization of such amounts to be more likely than not.
13
NET (LOSS) INCOME. As a result of the above factors, net income increased
$247,000 from a net loss of $233,000 for the three months ended June 30, 2004 to
net income of $14,000 for the three months ended June 30, 2005 and net income
increased $430,000 from a net loss of $323,000 for the six months ended June 30,
2004 to net income of $107,000 for the six months ended June 30, 2005. The
increase in net income for the six months ended June 30, 2005 compared to the
same period during 2004 is primarily the result of the addition of engineering
services and the Summit acquisition.
Liquidity and Capital Resources
Net cash provided by operating activities was $291,000 during the six
months ended June 30, 2005. The largest cost of sales is personnel costs and
this cost must be paid timely and cannot be delayed; thus as the Company's
revenues grow this will cause a use of cash in the interim period until the
revenue can be collected. The Company is able to borrow on its line of credit up
to 90% of its eligible accounts receivable to a maximum borrowing of $3.5
million. This borrowing capability helps the Company's cash flow until the
accounts receivable are collected.
During the six months ended June 30, 2005, the Company invested $98,000
primarily in computer equipment and furniture for engineering services. The
Company does not expect to have significant equipment purchases during the
remainder of 2005.
On January 3, 2005, the Company closed on its acquisition of Summit. Under
the terms of the Summit acquisition agreement, the Company (a) paid $1.6 million
in cash (of which $500,000 was in escrow at December 31, 2004) (b) issued
575,000 shares of the Company's common stock, (c) executed a $898,692 six-month
note and (d) executed a $2.7 million convertible promissory note. The
convertible note requires a $600,000 principal payment on December 31, 2005.
The principal portion of the convertible note may be converted at any time
by the note holder into the Company's common stock at a conversion price of
$2.25 per share. In the event the entire convertible note is converted, the
Company would issue 1.2 million shares of the Company's common stock. No
interest will accrue for the first six months and during any calendar month in
which the average closing price of the Company's common stock is greater than
$2.80 per share.
Net cash provided by financing activities for the six months ended June 30,
2005 was $674,000. The Company received $676,000 of proceeds from the exercise
of warrants and options and $421,000 from its line of credit. This was offset by
the payment of $423,000 to certain note holders during the six months ended June
30, 2005. On April 29, 2005, the Company executed a $374,304 convertible note
payable to its CEO to refinance two notes it had outstanding to the CEO. The
interest on the convertible debt is payable monthly with the principal due on
April 29, 2007. The CEO can convert the note into the Company's common stock at
a conversion price of $2.43 per share.
The Company's working capital, which consists of current assets less
current liabilities, increased from a negative $311,000 as of December 31, 2004
to $400,000 as of June 30, 2005. During 2005, the Company has funded its cash
needs through consistent collections of accounts receivable, through the
exercise of warrants and options and by borrowing on its line of credit, which
is secured by the Company's receivables and certain guarantees, at an interest
rate of prime.
14
Federal services revenues are expected to increase with the employment of
Gary Ryan as the Company's president during mid-2004, the addition of the
Company's engineering services during late 2004 and the acquisition of Summit
during January of this year.
Digital Fusion's ability to grow substantially may be dependent upon
obtaining cash flow from its operations and other external sources.
The Company has taken numerous actions to restructure and streamline its
operations. Most recently, the Company added engineering services during late
2004 and acquired Summit during early 2005. The Company has also obtained a line
of credit secured with its receivables and certain guarantees. Because of these
actions, management believes it has enough cash to meet its funding requirements
over the next year. The Company's current growth has been funded through
internally generated funds, the exercise of warrants and options and its line of
credit. Future growth will be supported with revenue from continuing operations,
which includes the Company's new engineering services and the acquisition of
Summit, a high technology engineering firm. If the Company fails to meet its
goals, seeks to expand its operations at a level above its current cash flow
from operations, or does not collect its accounts receivable in a timely manner,
it may require an infusion of working capital of which the availability and
terms cannot be predicted.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that have a significant impact on
the results reported in the financial statements. Some of the accounting
policies require management to make difficult and subjective judgments, often
because of the need to make estimates of matters that are inherently uncertain.
Digital Fusion's most critical accounting policies include accounts receivable
reserves and the valuation of goodwill. Actual results may differ from the
estimates under different assumptions or conditions. These policies are
discussed below, as are the estimates and judgments involved:
Revenue Recognition. We recognize revenue when persuasive evidence of an
arrangement exists, services have been rendered or good delivered, the contact
price is fixed or determinable, and collectibility is reasonably assured. The
majority of the Company's current contracts are with Federal Government
Departments or Agencies, or subcontracts to companies whose prime contracts are
with the Federal Government. Most of these contracts are Time and Material (T&M)
or Firm Fixed Price Level of Effort (FFP LOE). The LOE clause requires the
Company to have a certain number of labor hours and that these hours are worked
by personnel qualified to perform under certain labor categories. Revenue on
these contracts is recognized as time is expended and or materials are
delivered. The price is based on effort expended, not results achieved. The
revenue on these contracts is recognized by hours worked which serves as a proxy
for output. Revenue on cost-plus-fee contracts is recognized to the extent of
costs or hours actually incurred plus a proportional amount of the fee earned.
We consider fixed fees under cost-plus-fee contracts to be earned in proportion
to the allowable cost actually incurred in performance of the contract. The
Company's deferred revenue relates to payments we have received in advance of
services (hours worked).
15
From time to time, we may proceed with work based on customer direction
prior to the completion and signing of formal contract documents. We have a
formal review process for approving any such work. Revenue associated with such
work is recognized only when it can be reliably estimated and realization is
probable. We base our estimates on previous experiences with the client,
communications with the client regarding funding status, and our knowledge of
available funding for the contract or program.
Allowance for Doubtful Accounts. The Company's accounts receivable are
reduced by $29,000 for an allowance for amounts that may become uncollectible in
the future. The estimated allowance for uncollectible amounts is based on a
specific analysis of accounts in the receivable portfolio and a general reserve
based on the aging of receivables and historical write-off experience. The
Company's management believes the allowance to be reasonable. The Company does
not accrue interest on past due accounts receivable. As a result of improved
collections and a shift in business mix to government agencies, the Company has
reduced its allowance for doubtful accounts by $20,000 in three months ended
June 30, 2005.
Valuation of Goodwill and Intangible Assets. Goodwill and intangible assets
are reviewed annually for impairment or more frequently if impairment indicators
arise. This annual impairment test is performed in the last quarter of each
fiscal year. The goodwill impairment test requires a comparison of the fair
value of the Company to the amount of goodwill recorded. If this comparison
reflects impairment, then the loss would be measured as the excess of recorded
goodwill over its implied fair value. Although the Company's management believes
that the estimates and assumptions used are reasonable, actual results could
differ.
Item 3. Controls and procedures.
(a) Evaluation of disclosure controls and procedures. We maintain
disclosure controls and procedures designed to ensure that material information
related to us is recorded, processed, summarized and reported in accordance with
SEC rules and forms. Our management, with the supervision of the Chairman and
Chief Executive officer, Roy E. Crippen, III, has evaluated the effectiveness of
our disclosure controls and procedures as of the end of the period covered by
this report. Based upon that evaluation, Mr. Crippen has concluded that our
disclosure controls and procedures are effective in causing material information
to be recorded, processed, summarized and reported so as to ensure the quality
and timeliness of our public disclosures in compliance with SEC rules and forms.
(b) Changes in internal controls. There was no change in our internal
control over financial reporting that occurred during our most recent fiscal
quarter that has materially affected, or is reasonably likely to materially
affect our internal control over financial reporting.
16
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
No legal proceedings against the Company are required to be disclosed under
this Item pursuant to the requirements of Form 10-QSB.
Item 2. Changes in Securities.
Issuance of Unregistered Securities-
- ------------------------------------
On May 23, 2005, the Company issued 15,000 shares of its common stock at an
exercise price of $1.01 for exercise of warrants. The Company received proceeds
of $15,150 from the exercise of these warrants. On June 6, 2005, the Company
issued 212,839 shares of its common stock at an exercise price of $0.94 for
exercise of warrants. The Company received proceeds of $200,069 from the
exercise of these warrants. These shares were issued to accredited investors.
The company relied on Section 4(2) of the Securities Act of 1933 and Regulation
D thereunder as the basis for an exemption from registration for this issuance.
Item 3. Defaults upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders.
The following matters were submitted to a vote of security holders during
the Company's annual meeting of shareholders held on June 28, 2005:
Votes Authority
Cast For Withheld
-------------------- ------------------
1. Election of Directors:
Roy E. Crippen, III 8,919,444 1,210
Jay M. Garner 8,919,444 1,210
O.G. Greene 8,918,984 1,670
G. Stewart Hall 8,919,184 1,470
Frank Libutti 8,919,244 1,410
Charles F. Lofty 8,919,044 1,610
Gary S. Ryan 8,919,444 1,210
17
Broker
For Against Abstentions Non-Votes
2. Approval of the amendment to the Restated
Articles of Incorporation to increase the
number of authorized shares of common stock 8,512,642 407,912 100 0
3. Approval of the Company's 2005 Stock
Option Plan 5,479,315 399,116 6,260 3,035,963
4. Ratification of Pender Newkirk &
Company as the independent auditors
of the Company 8,899,964 20,240 450 0
Item 5. Other Information.
None.
Item 6. Exhibits.
(a) Exhibits
The following is a list of Exhibits filed as a part of this Report.
Exhibit No. Description
----------- -----------
*10.1 Convertible Promissory Note dated April 29, 2005 for
$374,303.52 between Roy E Crippen, III (CEO) and the
Company is incorporated herein by reference to
Exhibit 10.1 to the Form 8-K filed May 5, 2005.
*10.2 Registration Rights Agreement dated April 29, 2005
between Roy E. Crippen, III (CEO) and the Company is
incorporated herein by reference to Exhibit 10.2 to
the Form 8-K filed May 5, 2005.
*10.3 Consultant agreement dated March 30, 2005 between
Frank Libutti and the Company to provide business
development.
*10.4 Employment Agreement dated April 7, 2005 between
Digital Fusion and Christopher Brunhoeber
*10.5 Loan Agreement, Note and Security Agreement, each
dated May 25, 2005, among First Commercial Bank of
Huntsville and the Company, for a $3,500,000
revolving line of credit, is incorporated herein by
reference to Exhibit 10.1 to the Form 8-K filed May
31, 2005.
*31.1 Certification Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
18
*32.1 Certification Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002. (This exhibit shall not
be deemed "filed" for purposes of Section 18 of the
Securities Exchange Act of 1934, as amended, or
otherwise subject to the liability of that section.
Further, this exhibit shall not be deemed to be
incorporated by reference into any filing under the
Securities Act of 1933, as amended, or the Securities
Exchange Act of 1934, as amended.)
---------------
* Incorporated by reference.
** Filed herewith.
+ Management contract or compensatory plan or arrangement.
19
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
DIGITAL FUSION, INC.
Date: August 11, 2005
By: /s/ Christopher L. Brunhoeber
-------------------------------------
Name: Christopher L. Brunhoeber
Title: Vice President of Finance
(Principal Accounting Officer)
20