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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 September 30, 2005. (Third 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 of (I.R.S. Employer I.D. No.)
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 November 1, 2005, 11,071,564 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
PART I. FINANCIAL INFORMATION Page No.
--------
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of September 30, 2005
(unaudited) and December 31, 2004........................................ 1
Condensed Consolidated Statements of Operations for the
three and nine months ended September 30, 2005 and 2004 (unaudited)....... 2
Condensed Consolidated Statements of Cash Flows for
the nine months ended September 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........................................................... 17
Item 6. Exhibits.................................................................... 18
SIGNATURES........................................................................... 19
Section 302 CEO and CFO Certifications
Section 906 CEO and CFO Certifications
PART I FINANCIAL INFORMATION
Item 1. Financial Statements.
DIGITAL FUSION, INC.
Condensed Consolidated Balance Sheets
(In thousands)
September 30, 2005
(Unaudited) December 31, 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) 3,614 1,050
Unbilled receivables 614 --
Prepaid expenses and other current assets 73 27
------------ ------------
Total current assets 4,302 1,329
Property and equipment, net of accumulated depreciation of
$1,068 for 2005 and $952 for 2004 495 417
Prepaid acquisition costs and acquisition deposit -- 285
Goodwill 5,865 3,347
Purchased intangible assets, net 1,742 --
Other assets 18 13
------------ ------------
Total assets $ 12,422 $ 5,391
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Current maturities of long-term debt $ 1,442 $ 647
Accounts payable 1,414 609
Deferred revenue 405 21
Accrued compensation and related expenses 959 97
Other current liabilities 83 266
------------ ------------
Total current liabilities 4,303 1,640
Long-term debt, less current maturities 2,220 81
Pension obligation 302 302
------------ ------------
Total liabilities 6,825 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; 11,072 and 9,721
shares issued and outstanding at
September 30, 2005 and December 31,
2004, respectively 111 97
Additional paid in capital 44,069 42,050
Accumulated deficit (38,583) (38,779)
------------ ------------
Total stockholders' equity 5,597 3,368
------------ ------------
Total liabilities and stockholders' equity $ 12,422 $ 5,391
============ ============
See Accompanying Notes to Condensed Consolidated Financial Statements.
1
DIGITAL FUSION, INC.
Condensed Consolidated Statements of Operations
For the three and nine months ended September 30, 2005 and 2004
(Unaudited)
(In thousands, except per share amounts)
Three months ended Nine months ended
September 30, September 30,
------------------------ ------------------------
2005 2004 2005 2004
-------- ------- -------- -------
Revenues
Services and fees $ 4,060 $ 962 $ 11,107 $ 3,137
Reimbursed costs 815 191 1,993 461
Product 963 891 1,728 1,567
-------- ------- -------- -------
Total Revenues 5,838 2,044 14,828 5,165
-------- ------- -------- -------
Cost of services and goods sold
Services 3,163 846 8,605 2,527
Reimbursed costs 796 150 1,872 370
Product 877 845 1,608 1,478
-------- ------- -------- -------
Total cost of services and goods sold 4,836 1,841 12,085 4,375
-------- ------- -------- -------
Gross profit 1,002 203 2,743 790
Selling, general and administrative 678 472 1,925 1,309
-------- ------- -------- -------
Operating income (loss) 324 (269) 818 (519)
Other income (expenses):
Interest expense, net (54) (58) (137) (131)
Other income 1 -- 21 --
Amortization of intangible assets (101) -- (201) --
Amortization of discount on debt and
intrinsic value of convertible debt (81) -- (305) --
-------- ------- -------- -------
Total other expenses (235) (58) (622) (131)
-------- ------- -------- -------
Net income (loss) $ 89 $ (327) $ 196 $ (650)
======== ======= ======== =======
Basic earnings (loss) per share $ 0.01 $ (0.04) $ 0.02 $ (0.09)
======== ======= ======== =======
Basic weighted average common shares outstanding 11,051 7,985 10,792 7,599
======== ======= ======== =======
Dilute earnings (loss) per share $ 0.01 $ (0.04) $ 0.02 $ (0.09)
======== ======= ======== =======
Diluted weighted average common
shares outstanding 13,156 7,985 12,879 7,599
======== ======= ======== =======
See Accompanying Notes to Condensed Consolidated Statements.
2
DIGITAL FUSION, INC.
Condensed Consolidated Statements of Cash Flows
For the nine months ended September 30, 2005 and 2004
(Unaudited)
(In thousands)
2005 2004
------- --------
Cash flows provided by (used in) operating activities:
Net income (loss) $ 196 $(650)
Adjustments to reconcile net loss to net cash used in
operating activities, net of effect of acquisition:
Depreciation and amortization 118 72
Amortization of intangible assets 201 --
Amortization of beneficial interest 243 --
Amortization of discount on debt 62 --
Changes in assets and liabilities (187) 371
------- -----
Net cash provided by (used in) operating activities 633 (207)
------- -----
Cash flows used in investing activities:
Capital expenditures - property and equipment (139) (71)
Acquisition of Summit (1,182) --
------- -----
Net cash used in investing activities (1,321) (71)
------- -----
Cash flows provided by (used in) financing activities:
Proceeds from exercise of options and warrants 689 --
Repayments of notes payable (1,531) (536)
Net proceeds from equity sale 453
Net proceeds from line of credit 1,279 --
------- -----
Net cash provided by (used in) financing activities 437 (83)
------- -----
Net decrease in cash and cash equivalents (251) (361)
Cash and cash equivalents, beginning of periods 252 419
------- -----
Cash and cash equivalents, end of periods $ 1 $ 58
======= =====
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 nine months ended September 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 September 30, 2005, 590,750 stock options were granted to employees
and directors. During the nine months ended September 30, 2005, 1,561,250 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 nine months
ended September 30, 2005 and 2004, respectively. (in thousands, except per share
data):
4
Three Months Ended September 30, Nine Months Ended September 30,
2005 2004 2005 2004
------------------ ------------------ ------------------ -----------------
Net income (loss), as reported $ 89 $ (327) $ 196 $ (650)
Less: stock-based
compensation expense, net of tax $ (297) $ (61) $ (539) $ (136)
----------------- ----------------- ----------------- -----------------
Net loss, pro forma (208) (388) (343) (786)
================= ================= ================= =================
Basic net income (loss) per share :
As reported $ 0.01 $ (0.04) $ 0.02 $ (0.09)
================= ================= ================= =================
Pro forma $ (0.02) $ (0.05) $ (0.03) $ (0.10)
================= ================= ================= =================
Diluted net income (loss) per share:
As reported $ 0.01 $ (0.04) $ 0.02 $ (0.09)
================= ================= ================= =================
Pro forma $ (0.02) $ (0.05) $ (0.03) $ (0.10)
================= ================= ================= =================
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 4.08% 4.35%
Dividend yield 0% 0%
Expected life - years 10 10
Volatility 54% 57%
5
3. Earnings (Loss) Per Share Data
Common stock equivalents in the three and nine months ended September 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. However, if the company had net income the diluted
weighted average number of shares would have been 8,837,143 and 8,186,955 for
the three and nine months ended September 30, 2004, respectively.
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.
4. Income Taxes
The income tax expense for the Company's income from operations generated
during the nine months of 2005 was offset by a reduction in the valuation
allowance established against deferred tax assets arising from prior periods.
For the nine month period ended September 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. 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
Company's former Chief Executive Officer, Roy Crippen, by executing a $374,304
convertible note. The convertible note bears an annual interest rate of prime
and interest is payable monthly. Mr. Crippen 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 (a) extended the maturity date
to May 20, 2006, (b) stated the rate of interest at prime, payable monthly and
(c) 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 Research Corporation ("Summit") acquisition documents 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. The
Summit acquisition is described in more detail in section 7. below.
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. 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 Company has
not made adjustments to this estimate through September 30, 2005. 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 $1.9 million of
intangible assets represents $1.7 million allocated to customer base intangibles
and $275,000 allocated to employment and non-compete agreements.
(in thousands)
Accounts receivable $ 2,354
Fixed assets 57
Other assets 313
Goodwill 2,518
Intangible assets 1,943
-------
Total assets acquired 7,185
-------
Notes payable (300)
Accounts payable and accrued liabilities (1,186)
-------
Total liabilities assumed (1,486)
-------
Total purchase price $ 5,699
=======
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 nine months ended
September 30, 2004:
(in thousands)
Three months ended Six months ended
September 30, 2004 September 30, 2004
------------------ -----------------------
Revenues $ 4,325 $ 11,601
Net (loss) income $ (107) $ (77)
Basic earnings per share $ (0.01) $ (0.01)
Weighted average common stock shares
outstanding 8,560 8,174
9. Stockholders' Equity
A summary of the changes in stockholders' equity for the nine months
ended September 30, 2005 is as follows:
Stockholders' Equity
--------------------
Balance, December 31, 2004 $3,368
Net income 196
Shares issued in Summit purchase 575
Exercise of stock options and warrants 689
Beneficial interest Summit acquisition 769
Balance, September 30, 2005 $5,597
======
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 208,417 shares of common stock to fulfill stock option
and stock warrant exercises during the nine months ended September 30, 2005. The
stock options and stock warrants had exercise prices ranging from $0.33 to
$1.01. The Company received proceeds totaling $155,622 from the exercise of
these stock options and stock warrants during the nine months ended September
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 nine months
ending September 30, 2004 to conform to the 2005 presentation on its Condensed
Consolidated Statements of Operation.
9
11. Subsequent Events
As part of the Summit acquisition, a convertible promissory note for $2.7
million was issued. 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. On October 4, 2005, the company was notified that $299,999 of the
$600,000 principal payment due December 31, 2005 would be converted to company
common stock. Accordingly, the company will issue 133,333 share of company
common to the Summit note holder on January 3, 2006.
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.
10
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.
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 NINE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO THE THREE AND NINE
MONTHS ENDED JUNE 30, 2004
REVENUES. Service revenue increased approximately $3.1 million from $1.0
million for the three months ended September 30, 2004 to $4.1 million for the
three months ended September 30, 2005. Service revenue increased approximately
$8.0 million from $3.1 million for the nine months ended September 30, 2004 to
$11.1 million for the nine months ended September 30, 2005. Reimbursed costs
revenue increased approximately $624,000 from $191,000 for the three months
ended September 30, 2004 to $815,000 for the three months ended September 30,
2005. Reimbursed costs revenue increased approximately $1.5 million from
$461,000 for the nine months ended September 30, 2004 to $2.0 million for the
nine months ended September 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 $2.5 million and $6.9 million of increased
revenue, and the newly formed engineering services division accounted for $1.4
million and $3.3 million of revenues during the three and nine months ended
September 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 increased $72,000 from $891,000 in the three months ended
September 30, 2004 to $963,000 in the three months ended September 30, 2005.
Product revenues increased $161,000 rom $1,567,000 in the nine months ended
September 30, 2004 to $1,728,000 in the nine months ended September 30, 2005.
During the third quarter of 2004, Digital Fusion began selling the SPI Dynamics
Information Assurance product line WebInspect. 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 $2,317,000 to $3,163,000 for the three
months ended September 30, 2005. Cost of services increased by $6,078,000 to
$8,605,000 for the nine months ended September 30, 2005. The increase in cost of
services for the three and nine months ended September 30, 2005 compared to the
three and nine months ended September 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 $150,000
for the three months ended September 30, 2004 to $796,000 for the three months
ended September 30, 2005 and the increase in the reimbursed costs from $370,000
for the nine months ended September 30, 2004 to $1,872,000 for the nine months
ended September 30, 2005 is primarily due to the materials that are purchased
and resold to Summit and engineering services customers.
Product cost of goods sold increased by $32,000 to $877,000 for the three
months ended September 30, 2005 and increased by $130,000 to $1,608,000 for the
nine months ended September 30, 2005. The increases in product cost of goods
sold are primarily related to increases 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
September 30, 2005 is $897,000 or 22.1% of services revenues as compared to
$116,000, or 12.1% of services revenues for the three months ended September 30,
2004. Gross profit for services during the nine months ended September 30, 2005
is $2,502,000 or 22.5% of services revenues as compared to $610,000, or 19.4% of
services revenues for the nine months ended September 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
September 30, 2005 is $19,000 or 2.3% of reimbursed costs revenue as compared to
$41,000 and 21.5% of reimbursed costs revenue for the three months ended
September 30, 2004. Gross profit for the reimbursed costs during the nine months
ended September 30, 2005 is $121,000 or 6.1% of reimbursed costs revenue as
compared to $91,000 or 19.7% of reimbursed costs revenue for the nine months
ended September 30, 2004. The decrease in gross profit as a percentage of
reimbursed costs revenue is primarily related to the lower mark-up on material
purchased and resold to Summit and engineering services customers.
Gross profit for product was $86,000 or 8.9% for the three months ended
September 30, 2005 and $46,000 or 5.2% for the three months ended September 30,
2004. Gross profit for product was $120,000 or 6.9% for the nine months ended
September 30, 2005 and $89,000 or 5.7% for the nine months ended September 30,
2004. The increase in profit margin on product sales is primarily attributable
to more favorable pricing.
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 $206,000 for the three month ended September
30, 2005 compared to the three month ended September 30, 2004 and increased
$616,000 for the nine month ended September 30, 2005 compared to the nine month
ended September 30, 2004. The increase in SG&A is primarily related to the
addition of engineering services and the acquisition of Summit. SG&A as a
percent of revenue was 11.6% and 23.1% for the three months ending September 30,
2005 and 2004, respectively. SG&A as a percent of revenue was 13.0% and 25.3%
for the nine months ending September 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 remained relatively stable in the
three and nine months ended September 30, 2005 and 2004. Interest expense was
$54,000 in the three months ended September 30, 2005 and $58,000 for the three
months ended September 30, 2004, and was $137,000 in the nine months ended
September 30, 2005 and was $131,000 for the nine months ended September 30,
2004. Interest expense was affected by additional debt issued to the former
Summit shareholders for the acquisition of Summit, offset by strong cash
collections that reduced borrowings in the three months ended September 30,
2005.
OTHER INCOME. The $21,000 of other income recorded in the nine months ended
September 30, 2005 is primarily 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 $101,000 and the $201,000
amortization of intangible assets in the three and nine months ended September
30, 2005 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 $81,000 and $305,000 amortization of debt discount and intrinsic value of
the convertible debt in the three and nine months ended September 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.
13
INCOME TAX BENEFIT. The income tax expense for the Company's income from
operations generated during the three and nine months ended September 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
nine months ended September 30, 2004 based on uncertainties concerning its
ability to generate taxable income in future periods. The tax benefit for the
three and nine months ended September 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 if management considers realization of
such amounts to be more likely than not.
NET (LOSS) INCOME. As a result of the above factors, net income increased
$416,000 from a net loss of $327,000 for the three months ended September 30,
2004 to net income of $89,000 for the three months ended September 30, 2005 and
net income increased $846,000 from a net loss of $650,000 for the nine months
ended September 30, 2005 to net income of $196,000 for the nine months ended
September 30, 2005. The increase in net income for the three and nine months
ended September 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 $633,000 during the nine
months ended September 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 nine months ended September 30, 2005, the Company invested
$139,000 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.
As part of the Summit acquisition, a convertible promissory note for $2.7
million was issued. 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. On October 4, 2005, the company was notified that $299,999 of the
$600,000 principal payment due December 31, 2005 would be converted to company
common stock. Accordingly, the company will issue 133,333 share of company
common to the Summit note holder on January 3, 2006.
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.
14
Net cash provided by financing activities for the nine months ended
September 30, 2005 was $437,000. The Company received $689,000 of proceeds from
the exercise of warrants and options and $1,279,000 from its line of credit.
This was offset by the payment of $1,531,000 to certain note holders during the
nine months ended June 30, 2005. On April 29, 2005, the Company executed a
$374,304 convertible note payable to its CEO at the time 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 note can be converted by
the note holder 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 a negative $1,000 as of September 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 equal to the First Commerical Bank prime rate.
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:
15
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).
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.
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, Frank Libutti, 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. Libutti 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.
16
(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.
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 August 20, 2005, the Company issued 1,000 shares of its common stock at
an exercise price of $0.33 for exercise of warrants. The Company received
proceeds of $330 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.
None.
Item 5. Other Information.
None.
17
Item 6. Exhibits.
(a) Exhibits
The following is a list of Exhibits filed as a part of this Report.
Exhibit No. Description
*3.1 Amendment to the Bylaws of the Company, dated September 2, 2005 is
incorporated herein by reference to Exhibit 3.1 to the Form 8-K
filed September 2, 2005.
*10.1 Employment Agreement, dated January 3, 2005, by and between Digital
Fusion and Michael W. Wicks. +
*10.2 Employment Agreement, dated January 3, 2005, by and between Digital
Fusion and Steven Thornton. +
*10.3 Employment Agreement, dated January 3, 2005, by and between Digital
Fusion and Joseph L. Summers. +
*10.4 Amended and Restated Employment Agreement, dated February 28, 2005,
by and between Digital Fusion and Roy E. Crippen, III. +
*10.5 Amended and Restated Employment Agreement, dated February 28, 2005,
by and between Digital Fusion and Gary S. Ryan. +
*10.6 Convertible Promissory Note dated April 29, 2005 for $374,303.52
between Roy E Crippen, III (former CEO) and the Company is
incorporated herein by reference to Exhibit 10.1 to the Form 8-K
filed May 5, 2005.
*10.7 Registration Rights Agreement dated April 29, 2005 between Roy E.
Crippen, III (former CEO) and the Company is incorporated herein by
reference to Exhibit 10.2 to the Form 8-K filed May 5, 2005.
*10.8 Employment Agreement dated April 7, 2005 between Digital Fusion and
Christopher Brunhoeber. +
*10.9 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.
**10.10 Employment Agreement dated August 5, 2005 between Digital Fusion and
Eugene Edward Lyons, III. +
**10.11 First Amendment to Employment Agreement dated August 5, 2005 between
Digital Fusion and Christopher Brunhoeber. +
**10.12 Employment Agreement dated August 5, 2005 between Digital Fusion and
Elena I. Crosby. +
**10.13 Employment Agreement dated September 19, 2005 between Digital Fusion
and Frank Libutti. +
**10.14 Employment Agreement dated October 20, 2005 between Digital Fusion
and Stacey G. Rock. +
**10.15 Employment Agreement dated October 20, 2005 between Digital Fusion
and Omer Stephen Brown. +
18
**31.1 Certification of the Chief Executive Officer pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.
**31.2 Certification of the Chief Financial Officer pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.
**32.1 Certification of Chief Executive Officer 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.) **32.2 Certification of Chief Financial Officer 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.)
**32.2 Certification of Chief Financial Officer 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.) **32.2 Certification of Chief Financial Officer 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: November 14, 2005
By: /s/ Christopher L. Brunhoeber
-------------------------------------------------
Name: Christopher L. Brunhoeber
Title:Chief Financial Officer
(Principal Financial and Accounting Officer)
20