Conformed
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____ to _____
Commission File Number 0-26494
GSE Systems, Inc.
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(Exact name of registrant as specified in its charter)
Delaware 52-1868008
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(State of incorporation) (I.R.S. Employer Identification Number)
7133 Rutherford Rd, Suite 200, Baltimore MD. 21244
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (410) 277-3740
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
Title of each class Name of each exchange on which registered
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Common Stock, $.01 par value American Stock Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE
Indicate by check mark if the registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. Yes [ ] No [X]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or 15(d) of the Act. Yes [ ] No [X]
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [ X ] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ X ]
Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [X]
Indicate by check mark whether the registrant is a shell company (as
defined in rule 12(b)-2 of the Exchange Act). Yes [ ] No [X]
The aggregate market value of Common Stock held by non-affiliates as of
June 30, 2005 was $6,922,177 based on the closing price of such stock on that
date of $1.80.
The number of shares outstanding of each of the registrant's Common Stock
and Series A Cumulative Convertible Preferred Stock as of March 15, 2006:
Common Stock, par value $.01 per share 8,999,706 shares
Series A Cumulative Convertible Preferred Stock,
par value $.01 per share 42,500 shares
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's Proxy Statement for the 2006 Annual Meeting of
Stockholders to be filed pursuant to Regulation 14A under the Securities
Exchange Act of 1934, as amended, are incorporated by reference into Part III.
TABLE OF CONTENTS
PART I Page
Item 1. Business...................................................... 3
Item 1A. Risk Factors..................................................19
Item 1B. Unresolved Staff Comments.....................................23
Item 2. Properties....................................................23
Item 3. Legal Proceedings.............................................24
Item 4. Submission of Matters to a Vote of Security Holders..........24
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters...................................25
Item 6. Selected Consolidated Financial Data..........................27
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations.............................29
Item 7A. Quantitative and Qualitative Disclosures About Market Risk....44
Item 8. Financial Statements and Supplementary Data...................46
Item 9. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure................47
Item 9A. Controls and Procedures.......................................47
Item 9B. Other Information.............................................47
PART III
Item 10. Directors and Executive Officers of the Registrant*...........48
Item 11. Executive Compensation*.......................................48
Item 12. Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters*.......48
Item 13. Certain Relationships and Related Transactions*...............48
Item 14. Principal Accountant Fees and Services*.......................48
PART IV
Item 15. Exhibits and Financial Statement Schedules....................49
SIGNATURES....................................................50
Exhibits Index................................................51
* to be incorporated by reference from the Proxy Statement for the
registrant's 2006 Annual Meeting of Shareholders.
RETACT(R), GSE Systems(R), Thor(R), OpenSim(R), SmartTutor(R), SimSuite Pro(R),
ESmart(R), and GAARDS(R) are registered trademarks and GFLOW+(TM), GLOGIC+(TM),
GCONTROL+(TM), GPower+(TM), SimSuite Power(TM), SimExec(TM), eXtreme I/S(TM),
RACS(TM), PEGASUS Plant Surveillance and Diagnosis System(TM), SIMONTM,
BRUS(TM), SensBase(TM), Vista PINTM, and Java Applications & Development
Environment (JADE)TM are trademarks of GSE Systems, Inc. All other trademarks
used in this document are the property of their respective owners.
Cautionary Statement Regarding Forward-LookingStatements.
This report 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 Private Securities Litigation
Reform Act of 1995 provides a "safe harbor" for forward looking statements.
Forward-looking Statements are not statements of historical facts, but rather
reflect our current expectations concerning future events and results. We use
words such as "expects", "intends", "believes", "may", "will" and "anticipates"
to indicate forward-looking statements. Because these forward-looking statements
involve risks and uncertainties, there are important factors that could cause
actual results to differ materially from those expressed or implied by these
forward-looking statements, including, but not limited to, those factors set
forth under Item 1A - Risk Factors and those other risks and uncertainties
detailed in the Company's periodic reports and registration statements filed
with the Securities and Exchange Commission. We caution that these risk factors
may not be exhaustive. We operate in a continually changing business
environment, and new risk factors emerge from time to time. We cannot predict
these new risk factors, nor can we assess the effect, if any, of the new risk
factors on our business or the extent to which any factor or combination of
factors may cause actual results to differ from those expressed or implied by
these forward-looking statements.
If any one or more of these expectations and assumptions proves incorrect,
actual results will likely differ materially from those contemplated by the
forward-looking statements. Even if all of the foregoing assumptions and
expectations prove correct, actual results may still differ materially from
those expressed in the forward-looking statements as a result of factors we may
not anticipate or that may be beyond our control. While we cannot assess the
future impact that any of these differences could have on our business,
financial condition, results of operations and cash flows or the market price of
shares of our common stock, the differences could be significant. We do not
undertake to update any forward-looking statements made by us, whether as a
result of new information, future events or otherwise. You are cautioned not to
unduly rely on such forward-looking statements when evaluating the information
presented in this report.
PART I
ITEM 1. BUSINESS.
GSE Systems, Inc. ("GSE Systems", "GSE" or the "Company") is a world leader
in real-time, high fidelity simulation. The Company provides simulation and
educational solutions and services to the nuclear and fossil electric utility
industry, the chemical and petrochemical industries and to the US Military
Complex. In addition, the Company provides plant monitoring, and signal analysis
monitoring and optimization software primarily to the power industry.
The Company's annual report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K, and all amendments to those reports will be made
available free of charge through the Investor Relations section of the Company's
Internet website (http://www.gses.com) as soon as practicable after such
material is electronically filed with, or furnished to, the Securities and
Exchange Commission.
Recent Developments.
On June 21, 2005, the Board of Directors of GP Strategies Corporation ("GP
Strategies") approved plans to spin-off its 57% interest in GSE through a
special dividend to the GP Strategies' stockholders. On September 30, 2005, the
GP Strategies' stockholders received 0.283075 share of GSE common stock for each
share of GP Strategies common stock or Class B stock held on the record date of
September 19, 2005. Following the spin-off, GP Strategies ceased to have any
ownership interest in GSE. GP Strategies will continue to provide corporate
support services to GSE, including accounting, finance, human resources, legal,
network support and tax pursuant to a Management Services Agreement which
expires on December 31, 2006.
In 2005, the Company incurred a significant operating loss. The Company's
revenue and profitability were impacted by the low volume of orders logged in
2004 and 2005 and the Company's backlog decreased from $19.6 million at December
31, 2004 to $12.3 million at December 31, 2005. In addition, the Company
continued to spend heavily on business development activities in order to expand
the Company's simulation business into new sectors, such as integrating its
simulation capabilities with broader training and educational programs.
Accordingly, the Company's cash position weakened during the year, with total
cash used in operating activities of $1.9 million. The Company received $2.0
million through the sale of a Senior Subordinated Secured Convertible Note to
Dolphin Direct Equity Partners, LP ("Dolphin") in May 2005, and the Company
utilized $1.2 million of its $1.5 million credit facility in 2005. The Company
took actions that will reduce its operating expenses in 2006, including the
termination of a number of employees and by restructuring two facility leases.
In order to ensure that the Company has sufficient working capital in 2006,
the Company completed several financing transactions in early 2006. On February
28, 2006, the Company and Dolphin entered into a Cancellation and Warrant
Exchange Agreement (the "Cancellation Agreement ") under which Dolphin agreed to
cancel its Senior Subordinated Secured Convertible Promissory Note and cancel
its outstanding warrant to purchase 380,952 shares of GSE common stock at an
exercise price of $2.22 per share. In exchange for Dolphin's agreement to enter
into the Cancellation Agreement and for the participation of Dolphin Offshore
Partners, LP in the Preferred Stock transaction discussed below, the Company
paid off the Dolphin Note and agreed to issue a new warrant to purchase 900,000
shares of GSE common stock at an exercise price of $0.67 per share. Dolphin must
exercise the new warrant promptly after the Company certifies to Dolphin on or
after May 30, 2006 (the "Mandatory Exercise Date") that, among other things,
the current stock price shall not be less than $1.25 on the Mandatory Exercise
Date and that the average of the current stock prices for each trading day of
the 30 calendar day period up to and including the Mandatory Exercise Date is
not less than $1.25.
On February 28, 2006, the Company raised $4.25 million through the sale of
42,500 shares of Series A Cumulative Convertible Preferred Stock and Warrants by
means of a private placement to "accredited investors", as that term is used in
rules and regulations of the Securities and Exchange Commission. The Convertible
Preferred Stock is convertible at any time into a total of 2,401,130 shares of
GSE common stock at a conversion price of $1.77 per share. The conversion price
was equal to 110% of the closing price of the Company's Common Stock on February
28, 2006, the date the sale of the Convertible Preferred Stock was completed.
Each investor received a five-year warrant to purchase GSE common stock equal to
20% of the shares they would received from the conversion of the Convertible
Preferred Stock, at an exercise price of $1.77. In aggregate, the Company issued
warrants to purchase a total of 480,226 shares of GSE common stock. The
Convertible Preferred Stock holders are entitled to an 8% cumulative dividend,
payable on a semiannual basis every June 30 and December 30. If the Company does
not make two consecutive dividend payments on the dates such payments are due,
there will be an additional 30% warrant coverage of five-year warrants at a
conversion price of $1.77 per share. At any time after March 1, 2007, the
Company has the right to convert the Preferred Stock into shares of GSE common
stock when the average of the current stock price during the twenty trading days
immediately prior to the date of such conversion exceeds 200% of the Series A
Conversion Price. The holders of the Convertible Preferred Stock are entitled to
vote on all matters submitted to the stockholders for a vote, together with the
holders of the voting common stock, all voting together as a single class. The
holders of the Convertible Preferred Stock are entitled to the number of votes
equal to the number of GSE common stock that they would receive upon conversion
of their Convertible Preferred Stock.
The Company paid the placement agent 6% of the gross proceeds received by
the Company from the offering ($255,000) plus five-year warrants to purchase
150,000 shares of the Company's common stock at an exercise price of $1.77 per
share.
The proceeds were used to payoff the Dolphin Note and the Company's line of
credit balance and for other working capital purposes.
On March 7, 2006, the Company entered into a new loan and security
agreement with Laurus Master Fund, Ltd. The new agreement established a $5.0
million line of credit for the Company. The line is collateralized by
substantially all of the Company's assets and provides for borrowings up to 90%
of eligible accounts receivable, and 40% of eligible unbilled receivables (up to
a maximum of $1.0 million). The interest rate on this line of credit is based on
the prime rate plus 200-basis points, with interest only payments due monthly.
The Company issued to Laurus Master Fund, Ltd. a warrant to purchase up to
367,647 shares of GSE common stock at an exercise price of $.01 per share.
After the completion of the financing transactions discussed above, the
Company believes that it has sufficient liquidity and working capital for its
operations in 2006. However, if the Company is unable to operate profitably and
generate sufficient cash from operations, the availability under its new line of
credit may not be sufficient and the Company may be required to look for
additional capital to fund its operations. There can be no assurance that the
Company would be successful in raising such additional funds.
The Company believes it is positioned to take advantage of emerging trends
in the power industry including a global nuclear power renaissance driven by the
high cost of oil coupled with environmental concerns caused by fossil fuels. In
the U.S. alone, the operating licenses for 32 nuclear power plants will expire
over the next several years. Many of these plants are planning significant
upgrades to the physical equipment and control room technology in conjunction
with the license extensions. Both will result in the need to modify or replace
the existing plant control room simulators. The Company, having what it believes
is the largest installed base of existing simulators, over 65%, is well
positioned to capture a large portion of this business, although no assurance
can be given that it will be successful in doing so.
In the first quarter 2005, the Company completed an agreement with
Westinghouse Electric Company LLC to become their preferred vendor for the
development of simulators for the AP1000 reactor design. As a result of this
agreement, GSE will work closely with Westinghouse to finalize the verification
and validation of the AP1000 Reactor Human-Machine Interface for the Main
Control Room. GSE expended approximately $124,000 in 2005 on developing
simulation models for the AP1000 reactor. In turn, Westinghouse and GSE will
collaborate on new opportunities both internationally and domestically. Recent
reports indicate that the Chinese government expects to build 40 new nuclear
plants over the next 10 years utilizing Western technology. Most of these new
plants will require a stand alone simulator for which the Company believes it is
best qualified to supply.
In addition, in the second quarter 2005, the Company was awarded a $1.3
million contract, which will be completed April 2006, to develop simulation
models for the novel Pebble Bed Modular Reactor System (PBMR) being developed by
a South African company. The PBMR is a new high temperature gas cooled reactor
that is inherently safe and reliable. Each reactor is designed to produce 165
MW, enough to provide energy for 40,000 hours. The system is designed such that
additional reactors can easily be added as energy demand increases. The PBMR is
ideally suited for areas with current modest energy needs that are expected to
grow. GSE believes it is in an excellent position to provide the simulators that
will be required with each PBMR installation, although there is no guarantee the
Company will be awarded additional contracts.
In the fourth quarter 2005, the Company continued its penetration of the
worldwide nuclear power market by receipt of contract awards in the United
States, Europe, and Mexico, aggregating $3.2 million. It also sponsored a
simulation seminar in Shanghai, China that was widely attended by professionals
from the nuclear power industry, several Universities and the Chinese Central
Government.
Throughout the year, the Company continued its focus on the fossil power
segment of the power industry. In 2005, the Company logged fossil power orders
of over $3.8 million. The Company expects continued growth in this market
segment and is focusing on second time simulation buyers that now demand the
more sophisticated and realistic simulation models offered by the Company.
While GSE simulators are primarily utilized for power plant operator
training, the uses are expanding to include engineering analysis, plant
modification studies, and operation efficiency improvements for both nuclear and
fossil utilities. During plant construction, simulators are used to test control
strategies and ensure on-time start-up. After commissioning, the same tools can
be used to increase plant availability and optimize plant performance for the
life of the facility. In partnership with an industry leading optimization
company, GSE will be participating in DOE grant programs to utilize simulation
and optimization for DOE's clean coal power initiative.
Over the course of 2005, the Company continued to develop its concept of
integrating simulation with broader training programs and educational
initiatives giving customers a turnkey alternative to operator and maintenance
training. The Company believes that this offering is unique. In the fourth
quarter 2005, the Company announced the formation of the Emirates Simulation
Academy, LLC (ESA), a United Arab Emirates company, to build and operate
simulation training academies in the Arab Gulf Region. GSE is a 10% owner of
ESA. These simulation training centers will be designed to train and certify
indigenous workers for deployment to a nation's critical infrastructure
facilities including power plants, oil refineries, petro-chemical plants,
desalination units and other industrial facilities. In January 2006, the Company
announced the award of a contract valued at over $15 million from ESA to supply
five simulators and an integrated training program.
The Company continues to execute its plan with respect to military defense
simulation. Over the course of the year the Company's revenue from its
simulation work for the US Navy on their nuclear propulsion program grew to over
$2 million. The Navy selected GSE's technology for this program, which is
expected to extend through the year 2025. The Company also entered into an
agreement with Atlantis Systems Corporation, a leading training integrator
specializing in the military and commercial aviation markets worldwide, to
jointly market, win and execute contracts in the U.S. Government and Military
markets. Under the terms of the agreement, GSE will license its proprietary
simulation technology to Atlantis.
As of December 31, 2005, the Company's backlog was $12.3 million. However,
as of February 28, 2006 the backlog was $29.5 million, of which $17.0 million is
expected to be recognized as revenue in 2006.
Background.
GSE Systems was formed on March 30, 1994 to consolidate the simulation and
related businesses of S3 Technologies, General Physics International Engineering
& Simulation and EuroSim, each separately owned and operated by ManTech
International Corporation, GP Strategies Corporation and Vattenfall AB,
respectively. On December 30, 1994, GSE Systems expanded into the process
control automation and supply chain management consulting industry through its
acquisition of the process systems division of Texas Instruments Incorporated,
which the Company operated as GSE Process Solutions, Inc. ("Process").
In December 1997, the Company acquired 100% of the outstanding common stock
of J.L. Ryan, Inc. ("Ryan"), a provider of engineering modifications and upgrade
services to the power plant simulation market. The combination of the Company's
pre-existing technology with the technical staff of the acquired Ryan business
positioned the Company to be more competitive for modifications and upgrade
service projects within the nuclear simulation market.
In October 2002, GSE purchased the stock of ManTech Automation Systems
(Beijing) Company Ltd, from ManTech International Corp. The Chinese company,
which has five employees, was renamed GSE Systems Engineering (Beijing) Company
Ltd. This acquisition gave the Company a much needed base in China to pursue and
implement simulation projects in that emerging market.
In September 2003, the Company completed the sale of substantially all of
the assets of GSE Process Solutions, Inc. (Process) to Novatech, LLC (Novatech)
pursuant to an Asset Purchase Agreement, effective as of September 25, 2003, by
and between the Company, Process and Novatech. The Company received $5.5 million
in cash.
Simulation Business.
Power Simulation.
Industry History
The real-time simulation industry grew from the need to train people on
complex and potentially dangerous operations, without placing life or capital
assets at risk. Real-time simulation has been used for the training of plant
operators for the power industry, including both nuclear power plants and
conventional fossil fuel power plants (i.e., coal, oil, and natural gas), since
the early 1970s. Real-time simulation usage has traditionally centered on
initial training of operators and follow-on training of operators in emergency
conditions that can best be achieved through simulation replicating actual plant
operations.
In the nuclear power industry, use of a simulator that accurately reflects
the current actual plant design is mandated by the U.S. Nuclear Regulatory
Commission. This mandate resulted from the investigation of the accident at the
Three Mile Island nuclear plant in 1979, which was attributed, at least in part,
to operator error. The NRC requires nuclear plant operators to earn their
licenses through simulator testing. Each nuclear plant simulator must pass a
certification program to ensure that the initial plant design and all subsequent
changes made to the actual plant control room or plant operations are accurately
reflected in the simulator. Plant operating licenses are tied to simulator
certification.
Full scope power plant simulators are a physical representation of the
entire plant control room. The control panels are connected to an input/output
(I/O) system, which converts analog electrical signals to digital signals
understood by the simulation computer. The simulation computer houses the
mathematical models, which simulate the physical performance of the power
plant's systems such as the reactor core, steam boiler, cooling water, steam
turbine, electrical generator, plant system controls and electrical distribution
systems. Partial scope simulators can be viewed as a subset of a full scope
simulator. Instead of simulating the entire performance of the power plant, a
partial scope simulator might represent one or two critical systems such as the
steam turbine and/or electrical generator operation.
In the past, training simulators had to strike a delicate balance between
providing an accurate engineering representation of the plant, while still
operating in "real-time" in order to provide effective training. As computing
power has increased, so too has the capacity of simulators to provide more
accurate plant representations in real-time based upon simulation models
developed from engineering design codes.
Simulation also is used to validate proposed plant equipment changes to
confirm the results of such changes, prior to making the change in the plant,
which can save time and money, as well as reduce the risk of unsafe designs, for
the utility.
Demand for new simulators in the nuclear power industry shifted to the
international market in the 1990s, as the domestic market was limited to
upgrades and replacement of existing simulators. However, the Company believes
that the economics and importance of nuclear power to the U.S. energy supply may
result in the extension of the useful lives of U.S. nuclear power plants. Any
service life extension of a nuclear power plant is likely to require major
upgrades to the plant's equipment and technology, including its simulator.
Fossil fuel plant simulators are not required by law or regulation, but are
justified as a cost-effective approach to train operators on new digital control
systems being implemented at many fossil fuel power plants. The size, complexity
and price of a fossil plant simulator are much lower than for simulators used
for nuclear plants. Fossil plant simulators have traditionally used lower
fidelity (less sophisticated) mathematical models to provide an approximate
representation of plant performance. The demand for highly accurate models did
not exist in the early market for fossil simulators since the main use of the
simulator was to train operators on the functionality of distributed control
systems for plant start-up activities.
The deregulation of the power industry has forced utilities to view their
assets differently. Power plants must now be profit centers, and gaining the
maximum efficiency from the plant to become, or remain, competitive is a
paramount issue. The mindset of the operator has shifted, as plant operators now
must perform within narrower and narrower performance margins while still
maintaining safe operations. GSE believes its fossil fuel plant customers are
now recognizing the benefits of high fidelity simulation models that provide
highly accurate representations of plant operations to help plant operators and
management determine optimal performance conditions.
Beyond traditional operator training uses, the Company sees a significant
shift in the use of its simulators to test plant automation systems before they
are deployed in the actual plant. Control strategies and equipment set points
are validated on the simulator prior to plant start up to ensure the control
schemes work properly and the expected plant performance is achieved. Performing
these tests on a high fidelity simulator saves days or weeks in the plant start
up, thereby reducing cost and ensuring quicker revenue generation by the
utility.
Industry Future
The Company sees a renaissance in nuclear power generation both
domestically and internationally that will provide significant opportunities for
expansion of the Company's business. China has announced plans to build 40 new
nuclear plants by the year 2020. Russia has also announced plans for 40 new
plants by 2030. New plants are on the drawing board or under construction in
Finland, Slovakia, and Bulgaria. Domestically numerous utilities are preparing
applications for Construction and Operating Licenses under the DOE 2010
incentive program, a joint government/industry cost-shared effort to identify
sites for new nuclear power plants, develop advanced nuclear plant technologies,
and demonstrate new regulatory processes leading to a private sector decision to
order new nuclear power plants for deployment in the United States in the 2010
timeframe. Beyond new construction, numerous U.S. utilities are extending the
useful life of their current assets.
These license extension processes in the nuclear industry will result in
significant changes in plant equipment and control room technology. Based upon
U.S. Nuclear Regulatory Commission regulations, each training simulator is
required to reflect all changes that are made in the actual plant, thus when
changes in plant equipment and control room technology are made, the nuclear
power plants must either upgrade existing simulators or purchase brand new
simulators.
The second phenomena affecting the industry is the aging of the nuclear and
fossil plant operator workforce which will result in the need for simulation to
train the next generation of plant operators. The industry is faced with an
aging workforce at the same time new capacity is needed, thereby placing
significant pressure on the industry to find and train the next generation of
operations and maintenance personnel. According to the Energy Central Research
and Analysis Division white paper entitled The High Cost of Losing Intellectual
Capital, the U.S. Bureau of Labor Statistics predicts that 30% or more of the
existing workforce will be eligible for retirement in the next five years, and
it is believed that by 2012 there will be nearly 10,000 more utility industry
jobs then workers to fill them.
Therefore, the Company believes that these trends, if they come to fruition
in whole or even in part, represent a market opportunity for its real-time
simulation, plant optimization, asset management and condition monitoring
products and services.
GSE's solution
The Company's Simulation business is a leader in the development, marketing
and support of high fidelity, real-time, dynamic simulation software for the
electric utility industry. The Company has built or modified about 65 of the
approximately 75 full-scope simulators serving about 103 operating nuclear power
plants in the United States. Outside the United States, GSE has built or
modified about 73 of the approximately 167 full-scope simulators serving
approximately 329 operating nuclear power plants.
In 2005, the Company developed integrated training solutions which combine
the power of the Company's simulation technology with training content to
provide turn-key training for the power and process industries. These training
centers will help industry bridge the gap between college and university level
training, and real world experience through simulation. The students that
graduate from GSE's training centers will be eminently more valuable to the
market place.
In addition to operator training, the Company's simulation products and
services permit plant owners and operators to simulate the effects of changes in
plant configuration and performance conditions to optimize plant operation.
These features allow the Company's customers to understand the cost implications
of replacing a piece of equipment, installing new technology or holding
out-of-service assets. GSE has also developed a suite of tools based on
sophisticated signal analysis and simulation techniques to help its customers
manage their assets by determining equipment degradation before it severely
impacts plant performance.
The Company has also focused on upgrading older technology used in power
plants to new technology upgrades for plant process computers and safety
parameter display systems. As nuclear plants in the U.S. continue to age, the
Company will seek more business in this upgrade market.
GSE provides both turnkey solutions, including simulated hardware and
proprietary software, to match a specific plant, and discrete simulation
technology for specific uses throughout a plant. Its substantial investment in
simulation technology has led to the development of proprietary software tools.
These tools significantly reduce the cost and time to implement simulation
solutions and support long-term maintenance. The Company's high fidelity,
real-time simulation technology for power plant fluid, logic and control,
electrical systems and associated real time support software, JADE, is available
for use primarily on UNIX, Linux and Windows computer platforms. The Company's
eXtreme tools were designed for the Windows environment. Both technologies were
specifically designed to provide user friendly graphic interfaces to the
Company's high fidelity simulator.
In addition to the simulator market, the Company offers products aimed at
improving performance of existing plants by reducing the number of unplanned
outages due to equipment failure. Using advanced signal analysis techniques, the
Company's tools can predict when certain plant equipment needs to be replaced.
Replacement of critical equipment prior to failure permits effective planning
and efficient use of maintenance time during scheduled off-line periods.
Products of the Power Simulation business include:
* Java Applications & Development Environment (JADE), a Java-based application
that provides a window into the simulation instructor station and takes
advantage of the web capabilities of Java, allowing customers to access the
simulator and run simulation scenarios from anywhere they have access to the
web. JADE includes the following software modeling tools:
* Jflow, a modeling tool that generates dynamic models for flow and pressure
networks.
* Jcontrol, a modeling tool that generates control logic models from logic
diagrams.
* Jlogic, a modeling tool that generates control logic models from schematic
diagrams.
* Jelectric, a modeling tool that generates electric system models from
schematic and one-line diagrams.
* Jtopmeret, a modeling tool that generates two phase network dynamic models.
* Jdesigner, a JADE based intuitive graphic editor for all JADE tools.
* Jstation, a JADE based web-enabled Instructor Station.
* eXtreme Tools is a suite of software modeling tools developed under the
Microsoft Windows environment. It includes:
* XtremeFlow, a modeling tool that generates dynamic models for flow and
pressure networks.
* XtremeControl, a modeling tool that generates control logic models from
logic diagrams.
* XtremeLogic, a modeling tool that generates control logic models from
schematic diagrams.
* Xtreme Electric, a modeling tool that generates electric system models from
schematic and one-line diagrams.
* SimExec, and OpenSim are real-time simulation executive systems that control
all real-time simulation activities and allows for an off-line software
development environment in parallel with the training environment. OpenSim is
targeted for users of Microsoft Windows operating systems, while SimExec is
targeted for users of Microsoft Windows, UNIX and LINUX operating systems.
* SmartTutor, complementary software for instructor stations. It provides new
capabilities to help improve training methodologies and productivity. Using
Microsoft ActiveX controls, SmartTutor allows the control of the simulator
software directly from Microsoft Office products. The user can run training
scenarios directly from a Microsoft Word document, or he can plot and show
transients live within a Microsoft PowerPoint slide.
* eXtreme I/S, a Microsoft Windows based Instructor Station that allows the use
of Microsoft Word and PowerPoint to control the real-time simulation
environment. eXtreme I/S is a user-friendly tool for classroom training and
electronic report generation. It provides real-time plant performance directly
from the simulator during classroom training, which drastically increases
learning efficiency.
* Pegasus Surveillance and Diagnosis System, a software package for
semi-automatic plant surveillance and diagnostics, incorporates sophisticated
signal processing and simulation techniques to help operators evaluate the
condition and performance of plant components. Pegasus permits plant management
to identify degraded performance and replace components before they fail.
* SIMON, a computer workstation system used for monitoring stability of boiling
water reactor plants. SIMON assists the operator in determining potential
instability events, enabling corrective action to be taken to prevent
unnecessary plant shutdowns.
The Simulation business also provides consulting and engineering services
to help users plan, design, implement, and manage/support simulation and control
systems. Services include application engineering, project management, training,
site services, maintenance contracts and repair.
Strategy
The goal of the Power Simulation business is to expand its
business on four fronts:
* Continue serving its traditional customer base.
* Combine its simulation capability with training content to provide
totally integrated training solutions.
* Market its existing and upgraded simulation products and its newly
designed signal analysis products as plant optimization asset
management and condition monitoring tools.
* Leverage its existing engineering staff to provide additional services
to domestic and international clients.
Traditional Simulation Market. Nuclear power currently accounts for about
20% of the electrical power grid capacity in the United States and this
percentage will likely remain the same even as total capacity increases. Any new
nuclear power plants will likely be of the advanced reactor designs created by
Westinghouse, General Electric and Areva. These new designs require new
simulators and training programs, as they are different from the nuclear power
plant designs currently in operation. In addition to new power plants, existing
nuclear power plants will likely be required to remain on-line for a longer
period than originally expected. In order to stay in operation, many plants will
require life extension modifications. Since all existing U.S. nuclear power
plants went on-line before 1979, their designs and technology can also benefit
from the substantial advances in plant design and technology developed over the
past 25 years. For example, several of the Company's U.S. utility customers are
considering replacing their existing hard panel control rooms with modern
distributed control systems (DCS) as are common in fossil fuel plants, and which
have been implemented in Europe for several years. Significant changes to
control room instrumentation and overall control strategy from hard panel to DCS
generally require modification or replacement of the plant simulator. With the
largest installed base of nuclear plant simulators in the world, the Company
believes it is uniquely positioned to serve this market segment with new
simulation products and services. GSE has received several projects in the last
two years for implementing digital turbine control systems in U.S. plants.
As plants extend their useful life, many plan to "up-rate" the existing
capacity to increase electrical yield. By changing the capacity of certain
equipment in a plant, the utility can gain upwards of a 10%-15% increase in
output. Again, any such changes must be reflected in the control room simulator,
and operators must be trained on the new equipment before implementation.
In addition to the United States markets, several emerging regions of the
world are expanding their electrical capacity with both nuclear and fossil fuel
power plants. This is particularly the case in China and the Gulf Region of the
Middle East. In 2005 the Company made significant investments in both of these
regions, and as a result has identified a number of high impact opportunities
for full scope simulators and integrated training centers. GSE is increasing its
marketing efforts in both of these areas.
Classroom Simulation. In recent years the Company has upgraded numerous
training simulators to utilize standard PC technology. As an extension of the
PC-based simulator technology, the Company has developed tools which will allow
the training simulator to be used in a classroom setting, replacing the actual
control room panels with "soft-panel" graphics.
Increased training requirements and demands for performance improvement
have resulted in simulator training time becoming scarce. By providing the
actual training simulator models in a classroom setting, the value of the
simulator is increased by allowing more personnel the training advantages of
interactive, dynamic real time simulation.
The Company pioneered the technology to run a simulator on a PC several
years ago. However, the technology remains complex, which prevented wide
deployment of the simulator in classrooms. The Company has developed unique
software which allows simulator-based training lessons to be easily developed
and deployed in a classroom setting.
Simulation Beyond Training. In addition to operator training, the Company's
simulation products can meet this increased need for efficiency by assisting
plant operators in understanding the cost implications of replacing equipment,
installing new technology and maintaining out-of-service assets. In order to
exploit this potential, the Company has increased the fidelity of its simulation
products and is marketing its services to increase the fidelity of simulators
that are already in operation.
As computing power and networking technologies improve, several of the
Company's customers have started to migrate simulation technology from the
training organization to the engineering organization. The same full scope
simulation software that drives the simulated control room panels in a simulator
can be used with graphical representations of the panels so engineers can test
design changes and see how the balance of the plant will react to such changes.
GSE has developed a Java-based application to allow customers easier access to,
and use of, the simulation capabilities across the organization through network
communication.
Optimize Existing Engineering Resources. GSE's Power domestic service
organization focuses on simulator upgrades and retrofits. In addition to
domestic resources, GSE has developed a network of trained engineers in Russia,
Ukraine, Czech Republic, Bulgaria, and China. These foreign resources provide
low cost engineering and software development capabilities and are readily
available to supplement the United States engineering staff as necessary.
Strategic Alliances
Power's strategic alliances have enabled the Company to penetrate regions
outside the United States by combining the Company's technological expertise
with the regional presence and knowledge of local market participants. These
strategic alliances have also permitted the reduction of research and
development and marketing costs by sharing such costs with other companies.
In recent years, a significant amount of the Company's international
business has come from contracts in Eastern Europe, including the republics of
the former Soviet Union, the Pacific Rim and India. In order to acquire and
perform these contracts, the Company entered into strategic alliances with
various entities including Automation Systems Co. Inc., a subsidiary of Beijing
Jihang Automation (China); All Russian Research Institute for Nuclear Power
Plant Operation (Russia); Kurchatov Institute (Russia); PowerGen (England); Risk
Engineering Ltd. (Bulgaria); Samsung Electronics (Korea); Toyo Engineering
Corporation (Japan); and the Institute for Information Industry (Taiwan). In
March 2006, GSE completed a strategic alliance with the University of
Strathclyde in Glasgow, UK to develop a simulation training and plant
diagnostics center to serve the UK.
Competition
The Power Simulation business encounters intense competition. In the
nuclear simulation market, GSE competes directly with larger firms primarily
from Canada and Germany, such as L-3 Communications MAPPS Inc. and STN Atlas.
The fossil simulation market is represented by smaller companies in the U.S. and
overseas. Several of the Company's competitors have greater capital and other
resources than it has, including, among other advantages, more personnel and
greater marketing, financial, technical and research and development
capabilities. Customer purchasing decisions are generally based upon price, the
quality of the technology, experience in related projects, and the financial
stability of the supplier.
Customers
The Power Simulation business has provided approximately 200 simulation
systems to an installed base of over 75 customers worldwide. In 2005,
approximately 63% of the Company's revenue was generated from end users outside
the United States. Customers include, among others, Arizona Public Service,
Bernische Kraftwerke AG (Switzerland), Comission Federal De Electricidad
(Mexico), Constellation Energy Group, Emerson Process Management, Honeywell
Hi-Spec Solutions, Karnaraftsakerhet och Utbildning AB (Sweden), Nebraska Public
Power District, Battelle's Pacific Northwest National Laboratory, Pebble Bed
Modular Reactor (Pty) Ltd. (South Africa), and Nuclear Engineering Ltd. (Japan).
For the years ended December 31, 2005, 2004, and 2003 one Power Simulation
customer (Battelle's Pacific Northwest National Laboratory) accounted for
approximately 25%, 24%, and 29%, respectively, of GSE's consolidated revenue.
The Pacific Northwest National Laboratory is the purchasing agent for the
Department of Energy and the numerous projects GSE performs in Eastern and
Central Europe.
Sales and Marketing
The Company markets its Power Simulation products and services through a
network of direct sales staff, agents and representatives, systems integrators
and strategic alliance partners. Market-oriented business and customer
development teams define and implement specific campaigns to pursue
opportunities in the power marketplace.
The Company's ability to support its multi-facility, international and/or
multinational Power Simulation clients is facilitated by its network of offices
and strategic partners in the U.S. and overseas. Power Simulation offices are
maintained in Maryland and Georgia, and outside the U.S., in Sweden, and China.
In addition to the offices located overseas, the Company's ability to conduct
international business is enhanced by its multilingual and multicultural work
force. GSE has strategic relationships with systems integrators and agents
representing its interests in:
* Brazil * Bulgaria
* Czech Republic * Germany
* India * Japan
* Mexico * People's Republic of China
* Russia * Spain
* South Africa * South Korea
* Taiwan * Ukraine
* United Kingdom
Process Simulation.
Industry
Throughout the process industries there is continuing competitive pressure
and a reduction of technical resources, which is forcing process manufacturers
to turn to advanced technologies for real-time optimization, training, and
advanced process control. Operational efficiency is vital for companies to
remain competitive where many of the manufacturing industries operate on very
thin margins. There are only one or two advanced technology companies that offer
services fully across this spectrum, and GSE offers dynamic real-time simulation
capabilities for operator training into this segment.
GSE's Solution
The SimSuite Pro product was developed by GSE specifically for operator
training, and the GSE culture and expertise is one of customized project
execution and delivery. This marketplace places a high value on experience, both
company-wide and for the individuals on the project teams, so GSE promotes its
long history in training simulators, while also seeking new applications. The
SimSuite Pro package continues to be enhanced with features applicable not just
to the execution of professional training techniques, but also to the recording
and validating of process operator performance for potential certification.
Strategy
The core concepts of process simulation make the technology a basis for
other potential process improvement activities, such as Advanced Process Control
and Process Optimization, which is where some of the major GSE competition has
more business focus than for operator training. GSE will continue to emphasize
its operator training focus and strengths, as well as the application of the
process simulator for change management, where changes in the process, control
strategy, or operating procedures can be evaluated in real time before they are
applied to the actual process units. On-stream time is an important economic
factor, and there is recognizable value in avoiding the risk of unplanned
process disturbances from invalidated changes.
Competition
GSE's competitors are a varied group. There are major corporations offering
a wide range of products and services that include operator training simulators.
There are also companies focused on Process Technology and manufacturing
enhancement, such as Invensys and Honeywell who are DCS distributors to the
refining industry and provide operator simulation as part of their DCS offering.
There is a collection of companies with specific industry niches that enables
them to compete in operator training simulation, such as Invensys and RSI. There
are also the smaller training companies that compete at the lower cost levels of
Computer Based Training (CBT) or simple simulations close to CBT.
The GSE focus on training simulation is a business strength, and its vendor
independence, with the ability to integrate to different vendor's process
control systems, is also a value which is appreciated by customers. GSE can be
seen as a best-of-breed type of supplier because it is not tied to a major
control system, nor is it providing simulation software for engineering and
business management with high annual license fees.
Sales and Marketing
The Company will market its Process Simulation technologies through a
combination of techniques including its existing direct sales channel, sales
agents, and strategic alliance partners.
US Government and Military Simulation
Industry
With the increasing demand to improve Homeland Security, all levels of
government and civil emergency management personnel need to be trained in
responding to manmade or natural disasters. Since an Emergency Operations Center
(EOC) is not permanently staffed, there is a significant loss of proficiency
between disasters. When a disaster happens, the staff must assimilate many
streams of data at once and make decisions based upon the facts presented to
them.
Today, training is accomplished in one of two ways. First is the tabletop
exercise, where the EOC staff sits around a table and a scenario is presented to
them and they must think through the steps to take and articulate a response.
Experts are there to record the exercise and provide after action analysis. The
second is a very costly exercise utilizing civil authorities and support
organizations such as fire, police, civil works, hospitals, National Guard etc.
These are extremely expensive and time consuming exercises in terms of manpower
resources and after action analysis.
There are EOC facilities at the municipal, state and federal level.
In addition, it is estimated that the U.S. Government averages yearly
simulation procurements of over $4 billion for its military complex. The
simulation services range from building new simulators, to upgrading and
re-hosting existing simulators, to maintaining the installed base. The
simulators are for Air Force and Naval planes and helicopters, Navy ships and
shipboard systems, and Army tanks, trucks and ordinance systems, among many
other applications.
GSE's Solution
GSE has utilized its over 30 years of experience in real-time simulation
modeling and operations personnel training to produce the Real-time Emergency
Management Interactive Training System (REMITS). REMITS is a PC-based real-time
simulation software for training EOC staff for emergency response. It is modular
in design, versatile and scalable to the specific training objectives. It can
interface with emergency management software such that the REMITS training
environment will be identical to the actual EOC, thus allowing the emergency
staff to use and train on the actual systems they will use in the event of a
disaster. This provides the same level of stress and intensity as experienced in
a real emergency scenario. REMITS can perform Individual Skills Training in the
familiarization of EOC equipment and procedures for different emergency
scenarios. Leadership training can be accomplished to teach effective command
and control over available assets. Finally, Team Collaboration Training enables
the staff to train on effective communications, moving resources and working
with constrained equipments and assets.
Strategy
GSE is working closely with developers of emergency management
communications and tasking software to embed simulation into their offerings and
thereby gain access to market through their sales channels. In addition, the
Company teamed with Atlantis Systems USA to pursue the military simulation
market. Atlantis will provide the marketing leadership and the Company will
provide its simulation technology solutions to Atlantis. The Company sees this
as the most cost effective way of entering the military simulation market.
Competition
The competitors in this market range from very large companies like
Lockheed Martin and Northrup Grumman to government defined small and
disadvantaged businesses such as Eshota (Indian Nation) and DEI (small, minority
owned).
Sales and Marketing
GSE will market its product in the U.S. Homeland Security industry through
its existing sales channels and foreign markets through existing power
simulation partners and agents.
Competitive Advantages
The Company believes that it is in a strong position to compete in the
Simulation markets based upon the following strengths:
* Technical and Applications Expertise. GSE is a leading innovator and
developer of real-time software with more than 30 years of experience
producing high fidelity real-time simulators. As a result, the Company has
acquired substantial applications expertise in the energy and industrial
process industries. The Company employs a highly educated and experienced
multinational workforce of 123 employees, including approximately 84
engineers and scientists. Approximately 60% these engineers and scientists
have advanced science and technical degrees in fields such as chemical,
mechanical and electrical engineering, applied mathematics and computer
sciences.
* Proprietary Software Tools. GSE has developed a library of proprietary
software tools including auto-code generators and system models that
substantially facilitate and expedite the design, production and
integration, testing and modification of software and systems. These tools
are used to automatically generate the computer code and systems models
required for specific functions commonly used in simulation applications,
thereby enabling it or its customers to develop high fidelity real-time
software quickly, accurately and at lower costs.
* Open System Architecture. GSE's software products and tools are executed on
standard operating systems with third-party off-the-shelf hardware. The
hardware and operating system independence of its software enhances the
value of its products by permitting customers to acquire less expensive
hardware and operating systems. The Company's products work in the
increasingly popular Microsoft operating environment, allowing full
utilization and integration of numerous off-the-shelf products for improved
performance.
* International Strengths. Approximately 63% of the Company's 2005 revenue
was derived from international sales of its products and services. GSE has
a multinational sales force with offices located in Beijing, China, and
Nykoping, Sweden and agents and representatives in 22 other countries. To
capitalize on international opportunities and penetrate foreign markets,
the Company has established strategic alliances and partnerships with
several foreign entities.
Intellectual Property.
The Company depends upon its intellectual property rights in its
proprietary technology and information. GSE maintains a portfolio of patents,
trademarks (both registered and unregistered), copyrights (both registered and
unregistered), and licenses. While such patents, trademarks, copyrights and
licenses as a group are of material importance to the Company, it does not
consider any one patent, trademark, copyright, or license to be of such
importance that the loss or expiration thereof would materially affect any
segment or the Company as a whole. The Company relies upon a combination of
trade secrets, copyright, patent and trademark law, contractual arrangements and
technical means to protect its intellectual property rights. GSE distributes its
software products under software license agreements that grant customers
nonexclusive licenses for the use of its products, which are nontransferable.
Use of the licensed software is restricted to designated computers at specified
sites, unless the customer obtains a site license of its use of the software.
Software and hardware security measures are also employed to prevent
unauthorized use of the Company's software, and the licensed software is subject
to terms and conditions prohibiting unauthorized reproduction of the software.
The Company has several U.S. patents that were issued in the 1996
timeframe, none of which (individually or collectively) have a significant role
in the Company's current business operations. In accordance with Title 35 U.S.
Code Section 154, these patents have a duration of 20 years from the filing date
of the application, subject to any statutory extension, provided they are
properly maintained. The Company believes that all of the Company's trademarks
(especially those that use the phrase "GSE Systems") are valid and will have an
unlimited duration as long as they are adequately protected and sufficiently
used. The Company's licenses are perpetual in nature and will have an unlimited
duration as long as they are adequately protected and the parties adhere to the
material terms and conditions.
GSE has eight registered U.S. trademarks: RETACT, GSE Systems, THOR,
OpenSim, Smart Tutor, SimSuite Pro, ESmart and GAARDS. Some of these trademarks
have also been registered in foreign countries. The Company also claims
trademark rights to GLOW+, GLOGIC+, GCONTROL+, GPower+, SimSuite Power, SimExec,
eXtreme I/S, RACS, PEGASUS Plant Surveillance and Diagnosis System, SIMON, BRUS,
Sens Base and Vista PIN.
In addition, the Company maintains federal statutory copyright protection
with respect to its software programs and products, has registered copyrights
for some of the documentation and manuals related to these programs, and
maintains trade secret protection on its software products.
Despite these protections, the Company cannot be sure that it has protected
or will be able to protect its intellectual property adequately, that the
unauthorized disclosure or use of its intellectual property will be prevented,
that others have not or will not develop similar technology independently, or,
to the extent it owns patents, that others have not or will not be able to
design around those patents. Furthermore, the laws of certain countries in which
the Company's products are sold do not protect its products and intellectual
property rights to the same extent as the laws of the United States.
Industries Served.
The following chart illustrates the approximate percentage of the Company's
2005, 2004, and 2003 revenues by industries served:
2005 2004 2003
------------ ------------ ------------
Nuclear power industry 83% 85% 89%
Fossil power industry 14% 10% 9%
Other 3% 5% 2%
----------- ------------ ------------
Total 100% 100% 100%
=========== ============ ============
Contract Backlog.
The Company does not reflect an order in backlog until it has received a
contract that specifies the terms and milestone delivery dates. As of December
31, 2005, the Company's aggregate contract backlog totaled approximately $12.3
million as compared to $19.6 million as of December 31, 2004. However, as of
February 28, 2006, the backlog was $29.5 million, of which $17.0 million is
expected to be recognized as revenue in 2006.
Employees.
As of December 31, 2005, the Company had 123 employees as compared to 144
employees at December 31, 2004.
ITEM 1A. RISK FACTORS.
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The Company has limited cash resources. If the Company is unable to generate
adequate cash flow from operations, it will need additional capital to fund its
operations.
In 2005, the Company incurred a significant operating loss. The Company's
revenue and profitability were impacted by the low volume of orders logged in
2004 and 2005 and the Company's backlog decreased from $19.6 million at December
31, 2004 to $12.3 million at December 31, 2005. In addition, the Company
continued to spend heavily on business development activities in order to expand
the Company's simulation business into new sectors, such as integrating its
simulation capabilities with broader training and educational programs.
Accordingly, the Company's cash position weakened during the year, with total
cash used in operating activities of $1.9 million. The Company received $2.0
million through the sale of a Senior Subordinated Secured Convertible Note to
Dolphin Direct Equity Partners, LP ("Dolphin") in May 2005, and the Company
utilized $1.2 million of its $1.5 million credit facility in 2005. The Company
took actions that will reduce its operating expenses in 2006, including the
termination of a number of employees and by restructuring two facility leases.
In order to ensure that the Company has sufficient working capital in 2006,
the Company completed several financing transactions in early 2006. On February
28, 2006, the Company and Dolphin entered into a Cancellation and Warrant
Exchange Agreement (the "Cancellation Agreement ") under which Dolphin agreed to
cancel its Senior Subordinated Secured Convertible Promissory Note and cancel
its outstanding warrant to purchase 380,952 shares of GSE common stock at an
exercise price of $2.22 per share. In exchange for Dolphin's agreement to enter
into the Cancellation Agreement and for the participation of Dolphin Offshore
Partners, LP in the Preferred Stock transaction discussed below, the Company
paid off the Dolphin Note and agreed to issue a new warrant to purchase 900,000
shares of GSE common stock at an exercise price of $0.67 per share. Dolphin must
exercise the new warrant promptly after the Company certifies to Dolphin on or
after May 30, 2006 (the "Mandatory Exercise Date") that, among other things,
the current stock price shall not be less than $1.25 on the Mandatory Exercise
Date and that the average of the current stock prices for each trading day of
the 30 calendar day period up to and including the Mandatory Exercise Date is
not less than $1.25.
On February 28, 2006, the Company raised $4.25 million through the sale of
42,500 shares of Series A Cumulative Convertible Preferred Stock and Warrants by
means of a private placement to "accredited investors", as that term is used in
rules and regulations of the Securities and Exchange Commission. The Convertible
Preferred Stock is convertible at any time into a total of 2,401,130 shares of
GSE common stock at a conversion price of $1.77 per share. The conversion price
was equal to 110% of the closing price of the Company's Common Stock on February
28, 2006, the date the sale of the Convertible Preferred Stock was completed.
Each investor received a five-year warrant to purchase GSE common stock equal to
20% of the shares they would received from the conversion of the Convertible
Preferred Stock, at an exercise price of $1.77. In total, the Company issued
warrants to purchase a total of 480,226 shares of GSE common stock.
The proceeds were used to payoff the Dolphin Note and the Company's line of
credit balance and for other working capital purposes.
On March 7, 2006, the Company entered into a new loan and security
agreement with Laurus Master Fund, Ltd. The new agreement established a $5.0
million line of credit for the Company. The line is collateralized by
substantially all of the Company's assets and provides for borrowings up to 90%
of eligible accounts receivable, and 40% of eligible unbilled receivables (up to
a maximum of $1.0 million). The interest rate on this line of credit is based on
the prime rate plus 200-basis points, with interest only payments due monthly.
After the completion of the transactions discussed above, the Company
believes that it has sufficient liquity and working capital for its operations
in 2006. However, if the Company is unable to operate profitably and generate
sufficient cash from operations, the availability under its new line of credit
may note be sufficient and the Company may be required to look for additional
capital to fund its operations. There can be no assurance that the Company would
be successful in raising such additional funds.
The Company's expense levels are based upon its expectations as to future
revenues, so it may be unable to adjust spending to compensate for a revenue
shortfall. Accordingly, any revenue shortfall would likely have a
disproportionate effect on the Company's operating results.
The Company's revenue was $22.0 million, $29.5 million and $25.0 million
for the years ended December 31, 2005, 2004 and 2003, respectively. The
Company's operating income (loss) was ($4.7 million), $2,000 and ($1.0 million)
in 2005, 2004 and 2003, respectively. The Company's operating results have
fluctuated in the past and may fluctuate significantly in the future as a result
of a variety of factors, including purchasing patterns, timing of new products
and enhancements by the Company and its competitors, and fluctuating foreign
economic conditions. Since the Company's expense levels are based in part on its
expectations as to future revenues, the Company may be unable to adjust spending
in a timely manner to compensate for any revenue shortfall and such revenue
shortfalls would likely have a disproportionate adverse effect on operating
results. The Company believes that these factors may cause the market price for
its common stock to fluctuate, perhaps significantly. In addition, in recent
years the stock market in general, and the shares of technology companies in
particular, have experienced extreme price fluctuations. The Company's common
stock has also experienced a relatively low trading volume, making it further
susceptible to extreme price fluctuations.
Risk of International Sales and Operations.
Sales of products and the provision of services to end users outside the
United States accounted for approximately 63% of the Company's consolidated
revenue in 2005. The Company anticipates that international sales and services
will continue to account for a significant portion of its revenue in the
foreseeable future. As a result, the Company may be subject to certain risks,
including risks associated with the application and imposition of protective
legislation and regulations relating to import or export (including export of
high technology products) or otherwise resulting from trade or foreign policy
and risks associated with exchange rate fluctuations. Additional risks include
potentially adverse tax consequences, tariffs, quotas and other barriers,
potential difficulties involving the Company's strategic alliances and managing
foreign sales agents or representatives and potential difficulties in accounts
receivable collection. The Company currently sells products and provides
services to customers in emerging market economies such as Russia, Ukraine,
Bulgaria, and the Czech Republic. Although end users in the Ukraine accounted
for 18%, 21%, and 29% of the Company's consolidated revenue in 2005, 2004, and
2003, respectively, GSE's customer for these projects was Battelle's Pacific
Northwest National Laboratory, which is the purchasing agent for the U.S.
Department of Energy. The DOE provides funding for various projects in Eastern
and Central Europe. Accordingly, the Company is not subject to the political and
financial risks that are normally faced when doing business in the Ukraine. The
Company has taken steps designed to reduce the additional risks associated with
doing business in these countries, but the Company believes that such risks may
still exist and include, among others, general political and economic
instability, lack of currency convertibility, as well as uncertainty with
respect to the efficacy of applicable legal systems. There can be no assurance
that these and other factors w ill not have a material adverse effect on the
Company's business, financial condition or results of operations.
The Company relies on one customer for a substantial portion of its
revenue. The loss of this customer would have a material adverse effect upon the
Company's revenues and results of operations.
For the years ended December 31, 2005, 2004, and 2003, one Power Simulation
customer (Battelle's Pacific Northwest National Laboratory) accounted for
approximately 25%, 24%, and 29%, respectively, of the Company's consolidated
revenue. The Pacific Northwest National Laboratory is the purchasing agent for
the Department of Energy and the numerous projects the Company performs in
Eastern and Central Europe. If the Company lost this customer, the Company's
revenue and results of operations would be materially and adversely affected.
The Company's business is substantially dependent on sales to the nuclear power
industry. Any disruption in this industry would have a material adverse effect
upon the Company's revenue.
In 2005, 83% of GSE's revenue was from customers in the nuclear power
industry. The Company will continue to derive a significant portion of its
revenue from customers in the nuclear power industry for the foreseeable future.
The Company's ability to supply nuclear power plant simulators and related
products and services is dependent on the continued operation of nuclear power
plants and, to a lesser extent, on the construction of new nuclear power plants.
A wide range of factors affect the continued operation and construction of
nuclear power plants, including the political and regulatory environment, the
availability and cost of alternative means of power generation, the occurrence
of future nuclear incidents, and general economic conditions.
The Company's debt agreement as of December 31, 2005 imposes significant
operating and financial restrictions, which may prevent it from capitalizing on
business opportunities.
GSE's debt agreement imposes significant operating and financial
restrictions. These restrictions affect, and in certain cases limit, among other
things, the Company's ability to:
* incur additional indebtedness and liens;
* make capital expenditures;
* make investments and acquisitions and sell assets;
* consolidate, merge or sell all or substantially all of its assets.
There can be no assurance that these restrictions will not adversely affect
the Company's ability to finance its future operations or capital needs or to
engage in other business activities that may be in the interest of stockholders.
The Company is dependent on product innovation and research and development,
which costs are incurred prior to revenues for new products and improvements.
The Company believes that its success will depend in large part on its
ability to maintain and enhance its current product line, develop new products,
maintain technological competitiveness and meet an expanding range of customer
needs. The Company's product development activities are aimed at the development
and expansion of its library of software modeling tools, the improvement of its
display systems and workstation technologies, and the advancement and upgrading
of its simulation technology. The life cycles for software modeling tools,
graphical user interfaces, and simulation technology are variable and largely
determined by competitive pressures. Consequently, the Company will need to
continue to make significant investments in research and development to enhance
and expand its capabilities in these areas and to maintain its competitive
advantage.
The Company relies upon its intellectual property rights for the success of its
business; however, the steps it has taken to protect its intellectual property
may be inadequate.
Although the Company believes that factors such as the technological and
creative skills of its personnel, new product developments, frequent product
enhancements and reliable product maintenance are important to establishing and
maintaining a technological leadership position, the Company's business depends,
in part, on its intellectual property rights in its proprietary technology and
information. The Company relies upon a combination of trade secret, copyright,
patent and trademark law, contractual arrangements and technical means to
protect its intellectual property rights. The Company enters into
confidentiality agreements with its employees, consultants, joint venture and
alliance partners, customers and other third parties that are granted access to
its proprietary information, and limits access to and distribution of its
proprietary information. There can be no assurance, however, that the Company
has protected or will be able to protect its proprietary technology and
information adequately, that the unauthorized disclosure or use of the Company's
proprietary information will be prevented, that others have not or will not
develop similar technology or information independently, or, to the extent the
Company owns patents, that others have not or will not be able to design around
those patents. Furthermore, the laws of certain countries in which the Company's
products are sold do not protect the Company's products and intellectual
property rights to the same extent as the laws of the United States.
The industries in which GSE operates are highly competitive. This competition
may prevent the Company from raising prices at the same pace as its costs
increase.
The Company's businesses operate in highly competitive environments with
both domestic and foreign competitors, many of whom have substantially greater
financial, marketing and other resources than the Company. The principal factors
affecting competition include price, technological proficiency, ease of system
configuration, product reliability, applications expertise, engineering support,
local presence and financial stability. The Company believes that competition in
the simulation fields may further intensify in the future as a result of
advances in technology, consolidations and/or strategic alliances among
competitors, increased costs required to develop new technology and the
increasing importance of software content in systems and products. The Company
believes that its technology leadership, experience, ability to provide a wide
variety of solutions, product support and related services, open architecture
and international alliances will allow it to compete effectively in these
markets. As the Company's business has a significant international component,
changes in the value of the dollar could adversely affect the Company's ability
to compete internationally.
GSE will continue to pursue new acquisitions and joint ventures, and any of
these transactions could adversely affect its operating results or result in
increased costs or other problems.
The Company intends to continue to pursue new acquisitions and joint
ventures, a pursuit which could consume substantial time and resources.
Identifying appropriate acquisition candidates and negotiating and consummating
acquisitions can be a lengthy and costly process. The Company may also encounter
substantial unanticipated costs or other problems associated with the acquired
businesses. The risks inherent in this strategy could have an adverse impact on
the Company's results of operation or financial condition.
The nuclear power industry, the Company's largest customer group, is associated
with a number of hazards which could create significant liabilities for the
Company.
The Company's business could expose it to third party claims with respect
to product, environmental and other similar liabilities. Although the Company
has sought to protect itself from these potential liabilities through a variety
of legal and contractual provisions as well as through liability insurance, the
effectiveness of such protections has not been fully tested. Certain of the
Company's products and services are used by the nuclear power industry primarily
in operator training. Although the Company's contracts for such products and
services typically contain provisions designed to protect the Company from
potential liabilities associated with such use, there can be no assurance that
the Company would not be materially adversely affected by claims or actions
which may potentially arise.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES.
The Company is headquartered in a facility in Baltimore, Maryland
(approximately 20,000 square feet). The lease for this facility expires in 2008.
In addition, the Company leases office space domestically in Georgia and
internationally in China and Sweden. The Company leases these facilities for
terms ending between 2006 and 2008.
In conjunction with the move of its Process Automation business to its
Columbia, Maryland facility in May 2003, the Company subleased most of its
vacated facility in Baltimore, Maryland to Alpharma USPD Inc. for a five-year
period, although Alpharma could terminate the lease at the end of the second
year provided a six-month notice was given. Alpharma elected to terminate the
sublease on April 30, 2005. In May 2005, the Company's lease for the Baltimore
facility was amended to release the Company from its rental obligation for
14,000 sq.ft. of the total 34,000 sq. ft. being leased effective October 1, 2005
as the landlord had entered into a new lease with another tenant for this space.
In October 2005, the Company relocated its Maryland operations from its facility
in Columbia to the Baltimore facility.
In October 2005, the Company signed an "Assignment of Lease and Amendment
to Lease" that assigns and transfers to another tenant (the "assignee") the
Company's rights, title and interest in its Columbia, Maryland facility lease.
The assignee's obligation to pay rent under the Lease began on February 1, 2006.
The Company remains fully liable for the payment of all rent and for the
performance of all obligations under the lease through the scheduled expiration
of the lease, May 31, 2008, should the assignee default on their obligations.
In September 2001, the Company entered into a sublease agreement with
Infonetics (formerly ManTech Solutions & Technologies Corporation) in which
Infonetics subleased 1,432 sq. feet of space in the Columbia, Maryland facility.
The sublease terminated in October 2005.
In September 2001, the Company entered into a sublease agreement with MECx
(formerly ManTech Environmental Corp.) in which MECx subleased 2,088 sq. feet of
space in the Columbia, Maryland facility. In October 2005, MECx moved to the
Company's Baltimore facility and subleased 1,234 sq. ft. of that facility until
February 2006 when the sublease was terminated.
ITEM 3. LEGAL PROCEEDINGS.
The Company is from time to time involved in legal proceedings incidental
to the conduct of its business. The Company currently is not a party to legal
proceedings that, in the opinion of management, are likely to have a material
adverse effect on the Company's business, financial condition or results of
operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matter was submitted to a vote of security holders during the quarter
ended December 31, 2005.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The following table sets forth, for the periods indicated, the high and low
sale prices for the Company's common stock reported by the American Stock
Exchange:
2005
-------------------------------------
Quarter High Low
------------ ------ ------
First $2.76 $1.75
Second $2.20 $1.70
Third $1.80 $1.25
Fourth $1.58 $1.06
2004
-------------------------------------
Quarter High Low
------------ ------ ------
First $2.33 $1.72
Second $2.70 $1.45
Third $2.78 $2.35
Fourth $2.70 $1.95
The following table sets forth the equity compensation plan information for
the year ended December 31, 2005:
Number of securities to Weighted average exercise Number of securities
be issued upon exercise price of outstanding remaining available for
of outstanding options, options, warrants and future issuance under
Plan category warrants and rights rights equity compensation plans
- --------------------------------------------------------------------------------------------------------------------------
Equity compensation
plan approved by
security holders 1,917,678 $3.12 368,442
- --------------------------------------------------------------------------------------------------------------------------
Equity compensation
plan not approved
by security holders -- $ -- --
- --------------------------------------------------------------------------------------------------------------------------
Total 1,917,678 $3.12 368,442
- --------------------------------------------------------------------------------------------------------------------------
The Company's common stock is listed on the American Stock Exchange, where
it trades under the symbol "GVP".
There were approximately 72 holders of record of the common stock as of
March 15, 2006. The Company has never declared or paid a cash dividend on its
common stock. The Company currently intends to retain future earnings to finance
the growth and development of its business and, therefore, does not anticipate
paying any cash dividends in the foreseeable future on its common stock. In
December 2001, the Company issued to ManTech International Corp. 39,000 shares
of convertible preferred stock which accrued dividends at an annual rate of 6%
payable quarterly. ManTech elected to convert the preferred stock to common
stock in October 2003. At the date of the conversion, the Company's credit
facility restricted the Company from paying any dividends on the preferred
stock. At December 31, 2005, the Company had accrued dividends payable to
ManTech of $366,000. The unpaid dividends accrue interest at 6% per annum. At
December 31, 2005 the Company had an accrual for interest payable of $60,000.
The Company believes factors such as quarterly fluctuations in results of
operations and announcements of new products by the Company or by its
competitors may cause the market price of the common stock to fluctuate, perhaps
significantly. In addition, in recent years the stock market in general, and the
shares of technology companies in particular, have experienced extreme price
fluctuations. The Company's common stock has also experienced a relatively low
trading volume, making it further susceptible to extreme price fluctuations.
These factors may adversely affect the market price of the Company's common
stock.
On February 28, 2006, the Company raised $4.25 million through the sale of
42,500 shares of Series A Cumulative Convertible Preferred Stock and Warrants by
means of a private placement to "accredited investors", as that term is used in
rules and regulations of the Securities and Exchange Commission. The Convertible
Preferred Stock holders are entitled to an 8% cumulative dividend, payable on a
semiannual basis every June 20 and December 30. If the Company does not make two
consecutive dividend payments on the dates such payments are due, there will be
an additional 30% warrant coverage of five-year warrants at a conversion price
of $1.77 per share.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
Historical consolidated results of operations and balance sheet data
presented below have been derived from the historical financial statements of
the Company. This information should be read in connection with the Company's
consolidated financial statements.
(In Thousands, Except Per Share Data)
Years ended December 31,
------------------------------------------------------------------------
2005 2004 2003 2002 2001
-------------- -------------- ------------ ------------ -------------
Statements of Operations:
Contract revenue $ 21,950 $ 29,514 $ 25,019 $20,220 $25,509
Cost of revenue 18,603 22,715 19,175 16,660 19,744
-------------- -------------- ------------ ------------ -------------
Gross profit 3,347 6,799 5,844 3,560 5,765
-------------- -------------- ------------ ------------ -------------
Operating expenses:
Selling, general and administrative 6,958 5,543 6,343 6,506 6,036
Administrative charges from GP Strategies 685 974 100 - -
Depreciation and amortization 431 280 392 395 1,098
-------------- -------------- ------------ ------------ -------------
Total operating expenses 8,074 6,797 6,835 6,901 7,134
-------------- -------------- ------------ ------------ -------------
Operating income (loss) (4,727) 2 (991) (3,341) (1,369)
Interest expense, net (416) (176) (504) (55) (469)
Other income (expense), net 497 316 (273) 37 442
-------------- -------------- ------------ ------------ -------------
Income (loss) from continuing operations
before income taxes (4,646) 142 (1,768) (3,359) (1,396)
Provision (benefit) for income taxes 149 60 93 891 (153)
-------------- -------------- ------------ ------------ -------------
Income (loss) from continuing operations (4,795) 82 (1,861) (4,250) (1,243)
-------------- -------------- ------------ ------------ -------------
Income (loss) from discontinued operations,
net of income taxes - - (1,409) (1,693) 1,502
Income (loss) on sale of discontinued operations,
net of income taxes - 36 (262) - -
-------------- -------------- ------------ ------------ -------------
Income (loss) from discontinued operations - 36 (1,671) (1,693) 1,502
-------------- -------------- ------------ ------------ -------------
Net income (loss) $ (4,795) $ 118 $ (3,532) $(5,943) $ 259
============== ============== ============ ============ =============
Basic income (loss) per common share (1):
Continuing operations $ (0.53) $ 0.01 $ (0.61) $ (0.76) $ (0.24)
Discontinued operations - - (0.26) (0.29) 0.29
-------------- -------------- ------------ ------------ -------------
Net income (loss) $ (0.53) $ 0.01 $ (0.87) $ (1.05) $ 0.05
============== ============== ============ ============ =============
Diluted income (loss) per common share (1):
Continuing operations $ (0.53) $ 0.01 $ (0.61) $ (0.76) $ (0.24)
Discontinued operations - - (0.26) (0.29) 0.29
-------------- -------------- ------------ ------------ -------------
Net income (loss) $ (0.53) $ 0.01 $ (0.87) $ (1.05) $ 0.05
============== ============== ============ ============ =============
Weighted average common shares outstanding:
-Basic 8,999 8,950 6,542 5,863 5,217
============== ============== ============ ============ =============
-Diluted 8,999 9,055 6,542 5,863 5,259
============== ============== ============ ============ =============
As of December 31,
------------------------------------------------------------------------
2005 2004 2003 2002 2001
-------------- -------------- ------------ ------------ -------------
Balance Sheet data:
Working capital (deficit) $ (925) $ 2,175 $ 2,130 $ 5,450 $ 6,535
Total assets 11,982 14,228 16,536 28,894 33,674
Long-term liabilities 1,567 19 34 9,031 6,735
Stockholders' equity 897 5,945 5,679 8,111 13,852
(1) Basic and diluted income per common share for 2003 includes $2,140,000 preferred stock dividends and beneficial
conversion premium which was deducted from net loss to arrive at net loss attributed to common shareholders.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
On June 21, 2005, the Board of Directors of GP Strategies Corporation ("GP
Strategies") approved plans to spin-off its 57% interest in GSE through a
special dividend to the GP Strategies' stockholders. On September 30, 2005, the
GP Strategies' stockholders received 0.283075 share of GSE common stock for each
share of GP Strategies common stock or Class B stock held on the record date of
September 19, 2005. Following the spin-off, GP Strategies ceased to have any
ownership interest in GSE. GP Strategies will continue to provide corporate
support services to GSE, including accounting, finance, human resources, legal,
network support and tax pursuant to a Management Services Agreement which
expires on December 31, 2006.
In 2005, the Company incurred a significant operating loss. The Company's
revenue and profitability were impacted by the low volume of orders logged in
2004 and 2005 and the Company's backlog decreased from $19.6 million at December
31, 2004 to $12.3 million at December 31, 2005. In addition, the Company
continued to spend heavily on business development activities in order to expand
the Company's simulation business into new sectors, such as integrating its core
simulation capability with broader educational and training programs.
Accordingly, the Company's cash position weakened during the year, with total
cash used in operating activities of $1.9 million. The Company received $2.0
million through the sale of a Senior Subordinated Secured Convertible Note to
Dolphin Direct Equity Partners, LP ("Dolphin") in May 2005, and the Company
utilized $1.2 million of its $1.5 million credit facility in 2005. The Company
took actions that will reduce its operating expenses in 2006, including the
termination of a number of employees and by restructuring two facility leases.
In order to ensure that the Company has sufficient working capital in 2006,
the Company completed several financing transactions in early 2006. On February
28, 2006, the Company and Dolphin entered into a Cancellation and Warrant
Exchange Agreement (the "Cancellation Agreement ") under which Dolphin agreed to
cancel its Senior Subordinated Secured Convertible Promissory Note and cancel
its outstanding warrant to purchase 380,952 shares of GSE common stock at an
exercise price of $2.22 per share. In exchange for Dolphin's agreement to enter
into the Cancellation Agreement and for the participation of Dolphin Offshore
Partners, LP in the Preferred Stock transaction discussed below, the Company
paid off the Dolphin Note and agreed to issue a new warrant to purchase 900,000
shares of GSE common stock at an exercise price of $0.67 per share. Dolphin must
exercise the new warrant promptly after the Company certifies to Dolphin on or
after May 30, 2006 (the "Mandatory Exercise Date") that, among other things,
the current stock price shall not be less than $1.25 on the Mandatory Exercise
Date and that the average of the current stock prices for each trading day of
the 30 calendar day period up to and including the Mandatory Exercise Date is
not less than $1.25.
On February 28, 2006, the Company raised $4.25 million through the sale of
42,500 shares of Series A Cumulative Convertible Preferred Stock and Warrants by
means of a private placement to "accredited investors", as that term is used in
rules and regulations of the Securities and Exchange Commission. The Convertible
Preferred Stock is convertible at any time into a total of 2,401,130 shares of
GSE common stock at a conversion price of $1.77 per share. The conversion price
was equal to 110% of the closing price of the Company's Common Stock on February
28, 2006, the date the sale of the Convertible Preferred Stock was completed.
Each investor received a five-year warrant to purchase GSE common stock equal to
20% of the shares they would received from the conversion of the Convertible
Preferred Stock, at an exercise price of $1.77. In total, the Company issued
warrants to purchase a total of 480,226 shares of GSE common stock. The
Convertible Preferred Stock holders are entitled to an 8% cumulative dividend,
payable on a semiannual basis every June 30 and December 30. If the Company does
not make two consecutive dividend payments on the dates such payments are due,
there will be an additional 30% warrant coverage of five-year warrants at a
conversion price of $1.77 per share. At any time after March 1, 2007, the
Company has the right to convert the Preferred Stock into shares of GSE common
stock when the average of the current stock price during the twenty trading days
immediately prior to the date of such conversion exceeds 200% of the Series A
Conversion Price. The holders of the Convertible Preferred Stock are entitled to
vote on all matters submitted to the stockholders for a vote, together with the
holders of the voting common stock, all voting together as a single class. The
holders of the Convertible Preferred Stock are entitled to the number of votes
equal to the number of GSE common stock that they would receive upon conversion
of their Convertible Preferred Stock.
The Company paid the placement agent 6% of the gross proceeds received by
the Company from the offering ($255,000) plus five-year warrants to purchase
150,000 shares of the Company's common stock at an exercise price of $1.77 per
share.
The proceeds were used to payoff the Dolphin Note and the Company's line of
credit balance and for other working capital purposes.
On March 7, 2006, the Company entered into a new loan and security
agreement with Laurus Master Fund, Ltd. The new agreement established a $5.0
million line of credit for the Company. The line is collateralized by
substantially all of the Company's assets and provides for borrowings up to 90%
of eligible accounts receivable, and 40% of eligible unbilled receivables (up to
a maximum of $1.0 million). The interest rate on this line of credit is based on
the prime rate plus 200-basis points, with interest only payments due monthly.
The Company issued to Laurus Master Fund, Ltd. a warrant to purchase up to
367,647 shares of GSE common stock at an exercise price of $.01 per share.
After the completion of the financing transactions discussed above, the
Company believes that it has sufficient liquidity and working capital for its
operations in 2006. However, if the Company is unable to operate profitably and
generate sufficient cash from operations, the availability under its new line of
credit may not be sufficient and the Company may be required to look for
additional capital to fund its operations. There can be no assurance that the
Company would be successful in raising such additional funds.
Critical Accounting Policies and Estimates.
As further discussed in Note 2 to the consolidated financial statements, in
preparing the Company's financial statements, management makes several estimates
and assumptions that affect the Company's reported amounts of assets,
liabilities, revenues and expenses. Those accounting estimates that have the
most significant impact on the Company's operating results and place the most
significant demands on management's judgment are discussed below. For all of
these policies, management cautions that future events rarely develop exactly as
forecast, and the best estimates may require adjustment.
Revenue Recognition on Long-Term Contracts. The majority of the Company's
revenue is derived through the sale of uniquely designed systems containing
hardware, software and other materials under fixed-price contracts. In
accordance with Statement of Position 81-1 Accounting for Performance of
Construction-Type and Certain Production-Type Contracts, the revenue under these
fixed-price contracts is accounted for on the percentage-of-completion method.
This methodology recognizes revenue and earnings as work progresses on the
contract and is based on an estimate of the revenue and earnings earned to date,
less amounts recognized in prior periods. The Company bases its estimate of the
degree of completion of the contract by reviewing the relationship of costs
incurred to date to the expected total costs that will be incurred on the
project. Estimated contract earnings are reviewed and revised periodically as
the work progresses, and the cumulative effect of any change in estimate is
recognized in the pe riod in which the change is identified. Estimated losses
are charged against earnings in the period such losses are identified. The
Company recognizes revenue arising from contract claims either as income or as
an offset against a potential loss only when the amount of the claim can be
estimated reliably and realization is probable and there is a legal basis of the
claim.
Uncertainties inherent in the performance of contracts include labor
availability and productivity, material costs, change order scope and pricing,
software modification and customer acceptance issues. The reliability of these
cost estimates is critical to the Company's revenue recognition as a significant
change in the estimates can cause the Company's revenue and related margins to
change significantly from the amounts estimated in the early stages of the
project.
As the Company recognizes revenue under the percentage-of-completion
method, it provides an accrual for estimated future warranty costs based on
historical and projected claims experience. The Company's long-term contracts
generally provide for a one-year warranty on parts, labor and any bug fixes as
it relates to software embedded in the systems.
The Company's system design contracts do not provide for "post customer
support service" (PCS) in terms of software upgrades, software enhancements or
telephone support. In order to obtain PCS, the customers must purchase a
separate contract. Such PCS arrangements are generally for a one-year period
renewable annually and include customer support, unspecified software upgrades,
and maintenance releases. The Company recognizes revenue from these contracts
ratably over the life of the agreements in accordance with Statement of Position
97-2 Software Revenue Recognition.
Revenue from the sale of software licenses which do not require significant
modifications or customization for the Company's modeling tools are recognized
when the license agreement is signed, the license fee is fixed and determinable,
delivery has occurred, and collection is considered probable.
Revenues from certain consulting or training contracts are recognized on a
time-and-material basis. For time-and-material type contracts, revenue is
recognized based on hours incurred at a contracted labor rate plus expenses.
Capitalization of Computer Software Development Costs. In accordance with
Statement of Financial Accounting Standards (SFAS) No. 86 Accounting for the
Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, the
Company capitalizes computer software development costs incurred after
technological feasibility has been established, but prior to the release of the
software product for sale to customers. Once the product is available to be
sold, the Company amortizes the costs, on a straight line method, over the
estimated useful life of the product, which normally ranges from three to five
years. As of December 31, 2005, the Company has net capitalized software
development costs of $940,000. On an annual basis, and more frequently as
conditions indicate, the Company assesses the recovery of the unamortized
software computer costs by estimating the net undiscounted cash flows expected
to be generated by the sale of the product. If the undiscounted cash flows are
not sufficient to recover the unamortized software costs the Company will
write-down the investment to its estimated fair value based on future discounted
cash flows. The excess of any unamortized computer software costs over the
related net realizable value is written down and charged to operations.
Significant changes in the sales projections could result in an impairment with
respect to the capitalized software that is reported on the Company's
consolidated balance sheet.
Deferred Income Tax Valuation Allowance. Deferred income taxes arise from
temporary differences between the tax bases of assets and liabilities and their
reported amounts in the financial statements. As required by SFAS No. 109
Accounting for Income Taxes, management makes a regular assessment of the
realizability of the Company's deferred tax assets. In making this assessment,
management considers whether it is more likely than not that some or all of the
deferred tax assets will not be realized. The ultimate realization of deferred
tax assets is dependent upon the generation of future taxable income during the
periods in which those temporary differences become deductible. Management
considers the scheduled reversal of deferred tax liabilities and projected
future taxable income of the Company in making this assessment. A valuation
allowance is recorded to reduce the total deferred income tax asset to its
realizable value. As of December 31, 2005, the Company's largest deferred tax
asset related to a U.S. net operating loss carryforward of $20.4 million which
expires in various amounts over the next twenty years. The amount of loss
carryforward which can be used by the Company may be significantly limited. The
recovery of the net deferred tax asset could not be substantiated by currently
available objective evidence. Accordingly, the Company has established a $10.4
million valuation allowance for its deferred tax assets.
Results of Operations.
The following table sets forth the results of operations for the periods
presented expressed in thousands of dollars and as a percentage of contract
revenue.
Years ended December 31,
-----------------------------------------------------------------------------------
2005 % 2004 % 2003 %
----------- ----------- ------------ ----------- ----------- -----------
Contract revenue $ 21,950 100.0 % $ 29,514 100.0 % $ 25,019 100.0 %
Cost of revenue 18,603 84.7 % 22,715 76.9 % 19,175 76.6 %
----------- ----------- ------------ ----------- ----------- -----------
Gross profit 3,347 15.3 % 6,799 23.1 % 5,844 23.4 %
----------- ----------- ------------ ----------- ----------- -----------
Operating expenses:
Selling, general and administrative 6,958 31.7 % 5,543 18.8 % 6,343 25.4 %
Administrative charges from GP Strategies 685 3.1 % 974 3.3 % 100 0.4 %
Depreciation and amortization 431 2.0 % 280 1.0 % 392 1.6 %
----------- ----------- ------------ ----------- ----------- -----------
Total operating expenses 8,074 36.8 % 6,797 23.1 % 6,835 27.4 %
----------- ----------- ------------ ----------- ----------- -----------
Operating income (loss) (4,727) (21.5)% 2 0.0 % (991) (4.0)%
Interest expense, net (416) (1.9)% (176) (0.6)% (504) (2.0)%
Other income (expense), net 497 2.3 % 316 1.1 % (273) (1.1)%
----------- ----------- ------------ ----------- ----------- -----------
Income (loss) from continuing operations
before income taxes (4,646) (21.1)% 142 0.5 % (1,768) (7.1)%
Provision for income taxes 149 0.7 % 60 0.2 % 93 0.3 %
----------- ----------- ------------ ----------- ----------- -----------
Income (loss) from continuing operations (4,795) (21.8)% 82 0.3 % (1,861) (7.4)%
----------- ----------- ------------ ----------- ----------- -----------
Loss from discontinued operations,
net of income taxes - 0.0 % - 0.0 % (1,409) (5.6)%
Income (loss) on sale of discontinued
operations, net of income taxes - 0.0 % 36 0.1 % (262) (1.1)%
----------- ----------- ------------ ----------- ----------- -----------
Income (loss) from discontinued operations - 0.0 % 36 0.1 % (1,671) (6.7)%
----------- ----------- ------------ ----------- ----------- -----------
Net income (loss) $ (4,795) (21.8)% $ 118 0.4 % $ (3,532) (14.1)%
=========== =========== ============ =========== =========== ===========
Comparison of the Years Ended December 31, 2005 to December 31, 2004
Contract Revenue. Contract revenue decreased 25.6% from $29.5 million in
2004 to $22.0 million in 2005 primarily as a result of a decline in orders and
lower volumes. In addition, the Company has an outstanding claim with a customer
for work performed through December 31, 2005 of approximately $265,000, for
which $120,000 has been recognized in 2005. Total orders logged in 2005 totaled
$15.3 million as compared to $18.9 million in 2004. As of December 31, 2005, the
Company's backlog was $12.3 million; however, as of February 28, 2006 the
backlog was $29.5 million, of which $17.0 million is expected to be recognized
as revenue in 2006.
Gross Profit. Gross profit totaled $3.3 million (15.3% of revenue) for the
year ended December 31, 2005 as compared with $6.8 million (23.1% of revenue)
for the year ended December 31, 2004. The decline in gross profit is directly
related to a decrease in contract revenue and certain adjustments made by the
Company during 2005 to the estimated costs to complete several of its long-term
contracts, which resulted in a net reduction of the contract-to- date gross
profit recognized of approximately $895,000 or 4% of revenue.
Selling, General and Administrative Expenses. Selling, general and
administrative ("SG&A") expenses for the year ended December 31, 2005 increased
25.5% from the prior year; from $5.5 million in 2004 to $7.0 million in 2005.
Business development costs increased from $2.8 million for the year ended
December 31, 2004 to $3.0 million in 2005, an 8.0% increase. The Company
expanded its business development organization throughout 2004 into the first
quarter of 2005, adding an additional five employees between the first quarter
2004 and the first quarter 2005. In addition, the Company incurred higher
bidding and proposal costs in the pursuit of new orders. In order to reduce
operating expenses, the Company terminated several of its business development
personnel in mid-2005 and reassigned others to operating positions. The
Company's corporate and G&A expenses increased 43.4% in 2005, from $2.5 million
in 2004 to $3.7 million in 2005. The increase reflects severance costs of
$301,000 in 2005 (of which $23,000 had not been paid as of December 31, 2005),
bad debt expense of $496,000, and the salary and benefit costs of the Company's
CEO who became a GSE employee in December 2004. Prior to December 2004, the
Company was charged for the CEO's services by GP Strategies and his costs were
classified as GP Strategies administration fees.
Software and other development expenditures were $758,000 in 2005 and
$552,000 in 2004 of which $275,000 and $191,000 was expensed in 2005 and 2004,
respectively. The Company capitalized $483,000 of software development costs in
2005 as compared to $361,000 in 2004. The Company's capitalized costs in 2005
were related to:
* Enhancements to JADE (Java Applications & Development Environment), a
Java-based application that provides a window into the simulation station
and takes advantage of the web capabilities of Java, allowing customers to
access the simulator and run scenarios from anywhere they have access to
the web. JADE 3.0 was released in April 2005.
* The continued development of the Company's REMITS product used to simulate
the operation of Emergency Operations Centers (EOC) run by municipal and
state governments.
* The development of generic simulation models representing the Westinghouse
Electric Company LLC AP1000 nuclear plant design.
* The development of new features for the Xflow modeling tool for modeling
power plant buildings.
The Company anticipates that its total gross development spending in 2006 will
approximate $700,000.
Administrative Charges from GP Strategies. On January 1, 2004, the Company
entered into a Management Services Agreement with GP Strategies Corporation in
which GP Strategies agreed to provide corporate support services to GSE,
including accounting, finance, human resources, legal, network support and tax.
Expense for these services was $685,000 in both 2005 and 2004. On September 30,
2005, GP Strategies spun-off its 57% interest in GSE through a special dividend
to the GP Strategies' stockholders. Despite the spin-off, the Management
Services Agreement has been extended through December 31, 2006 without an
increase. In 2004, the Company was also charged $298,000 for salary and benefits
of its CEO who was a GP Strategies employee until December 16, 2004.
Depreciation and Amortization. Depreciation expense totaled $431,000 and
$280,000 for 2005 and 2004, respectively. Due to the relocation of the Company's
Maryland operations from Columbia, Maryland to Baltimore, Maryland, the Company
accelerated the depreciation of certain leasehold improvements in 2005.
Operating Income (Loss) The Company had an operating loss of $4.7 million
(21.5% of revenue) in 2005 as compared with operating income of $2,000 in 2004.
The 2005 operating loss was due to the factors outlined above.
Interest Expense, Net. Net interest expense increased from $176,000 in 2004
to $416,000 in 2005. The Company incurred interest expense of $96,000 on the
Dolphin Note in 2005. Also included in 2005 interest expense was original issue
discount accretion related to the Dolphin Note and GSE Warrant of $203,000. See
the Liquidity and Capital Resources discussion below.
The Company incurred interest expense of $58,000 on borrowings against its
$1.5 million credit facility. In 2004, the Company had no borrowings against the
credit facility.
Amortization of deferred financing costs totaled $37,000 in 2005 and
$111,000 in 2004.
Other Income (Expense), Net. Other income (expense), net was $497,000 and
$316,000 in 2005 and 2004, respectively.
In conjunction with the Dolphin Note and GSE Warrants, the fair value of
the GSE Warrant was $375,000 and the fair value of the Conversion Option of the
Dolphin Note was $959,000. The GSE Warrant and Conversion Option liabilities are
marked to market through earnings on a quarterly basis in accordance with EITF
No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in a Company's Common Stock. In 2005, the Company recognized
a gain of $636,000 from the change in fair market value of these liabilities as
of December 31, 2005. See the Liquidity and Capital Resources discussion below.
At December 31, 2005, the Company had contracts for the sale of
approximately 247 million Japanese Yen at fixed rates. The contracts expire on
various dates through May 2007. The Company has not designated the contracts as
hedges and, accordingly, has recorded the change in the estimated fair value of
the contracts during 2005 of ($170,000) in other income (expense), net. The
estimated fair value of the contracts was $31,000 as of December 31, 2005.
At December 31, 2004, the Company had contracts for the sale of
approximately 435 million Japanese Yen at fixed rates. The Company has not
designated the contracts as hedges and, accordingly, recorded the change in the
estimated fair value of the contracts of $203,000 in other income (expense).
Provision for Income Taxes. In 2005, the Company's tax provision was
$149,000 and consisted of foreign taxes of $103,000, deferred taxes of $50,000
and state taxes of ($4,000). The Company has a full valuation allowance on its
deferred tax assets.
The Company's tax provision in 2004 was $90,000; $60,000 related to
continuing operations and $30,000 related to discontinued operations. The
provision consisted of state taxes of $18,000, U.S. alternative minimum tax of
$1,000, foreign taxes of $121,000 and deferred taxes of ($50,000).
Income on Sale of Discontinued Operations. Income from discontinued
operations was $36,000 in 2004 related to the Company's Process Simulation
business sold in 2003.
Comparison of Year Ended December 31, 2004 to December 31, 2003.
Contract Revenue. Revenue for the year ended December 31, 2004 was $29.5
million versus $25.0 million for the year ended December 31, 2003, an 18.0%
increase. The increase reflected the significant order volume logged in 2003.
Gross Profit. Gross profit increased from $5.8 million (23.4% of revenue)
for the year ended December 31, 2003 to $6.8 million (23.1% of revenue) for the
year ended December 31, 2004. The slight decrease in gross profit percentage is
mainly attributable to adjustments made by the Company in the third quarter 2004
to the estimated costs to complete several of its long-term contracts which
resulted in a net reduction of the project-to-date revenue and gross profit
recognized on the projects of approximately $288,000. The impact of these
adjustments was partially offset by:
* a 13.7% decrease in the Company's overhead costs in 2004 together with
a higher revenue base to recover the Company's relatively fixed
overhead costs, and
* higher stand-alone license revenue in 2004 ($1.0 million) as compared
to the prior year ($175,000) which have higher margins than projects.
Selling, General and Administrative Expenses. Selling, general and
administrative ("SG&A") expenses totaled $5.5 million for the year ended
December 31, 2004, a 12.7% decrease from the $6.3 million spent on SG&A in 2003.
Business development costs increased from $1.8 million for the year ended
December 31, 2003 to $2.8 million in 2004. This reflected the Company's renewed
focus on business development in 2004 and the reassignment of four operating
personnel into the business development function on January 1, 2004. In
addition, the Company hired several consultants in 2004 to assist in the bidding
and proposal activities of its new US government and military simulation
division. The Company's corporate and G&A expenses decreased from $4.2 million
in 2003 to $2.5 million in 2004 reflecting the outsourcing of the Company's
corporate function to GP Strategies on January 1, 2004 and reduced insurance
expense due to the inclusion of the Company under GP Strategies insurance
policies. Gross spending on software product development ("development")
totaled $552,000 in the year ended December 31, 2004 as compared to $856,000 in
2003. The reduction in gross development spending mainly reflects the release of
JADE version 2.0 at the end of 2003. JADE is a Java-based application that
provides a window into the simulation instructor station and takes advantage of
the web capabilities of Java, allowing customers to access the simulator and run
simulation scenarios from anywhere they have access to the web.
The Company capitalized $361,000 of development expenditures in 2004 as
compared to $542,000 in 2003. The Company's development expenditures in 2004,
certain of which were capitalized, were related to:
* The development of new functionality for the Company's Jtools software
modeling tools.
* The modification of the Company's simulation technology to simulate
the operation of Emergency Operations Centers (EOC) run by municipal
and state governments.
* The embedding of the Company's full scope simulator software into
classroom training materials by segmenting its simulation software
into "pieces" so that the software can be utilized to teach specific
skills in operating the nuclear electric utilities without the need
for control room panels.
* Additional enhancements to JADE (Java Applications & Development
Environment), a Java-based application that provides a window into the
simulation station and takes advantage of the web capabilities of
Java, allowing customers to access the simulator and run scenarios
from anywhere they have access to the web. JADE 3.0 was released in
the second quarter 2005.
Administrative Charges from GP Strategies. On January 1, 2004, the Company
entered into a Management Services Agreement with GP Strategies Corporation in
which GP Strategies agreed to provide corporate support services to GSE,
including accounting, finance, human resources, legal, network support and tax.
In addition, GSE uses General Physics' financial system. (General Physics is a
subsidiary of GP Strategies.) In 2004, GSE was charged $685,000 for General
Physics' services and $289,000 for salary and benefits of the Company's CEO who
was a GP Strategies employee until December 16, 2004.
Depreciation and Amortization. For the years ended December 31, 2004 and
2003, depreciation expense totaled $280,000 and $392,000, respectively. The
reduction reflects certain assets becoming fully depreciated.
Operating Income (Loss). The Company had an operating income of $2,000 for
the year ended December 31, 2004, as compared with an operating loss of $991,000
(4.0% of revenue) for the prior year. The variances were due to the factors
outlined above.
Interest Expense, Net. Net interest expense decreased from $504,000 in the
year ended December 31, 2003 to $176,000 for the year ended December 31, 2004.
Such amounts included amortization of deferred financing costs of $108,000 and
$111,000, respectively.
In September 2003, the Company paid off its outstanding bank debt from the
cash proceeds of the sale of the Process business. The interest expense incurred
on the outstanding bank debt in 2003 prior to the pay down was included in the
costs of the discontinued business. The Company did not borrow against its $1.5
million credit facility in 2004.
In March 2003, GP Strategies extended their $1.8 million limited guarantee
of the Company's bank facility for a one-year period. In consideration for the
extension of the guarantee, the Company issued 150,000 shares of its common
stock to GP Strategies. The number of shares was calculated based upon a 10% fee
divided by the closing price of GSE's common shares on March 21, 2003. The cost
of the guarantee was amortized over the one-year period; GSE recognized $45,000
of interest expense in the first quarter 2004 which completed the amortization
of these costs.
Other Income (Expense), Net. At December 31, 2004, the Company had
contracts for sale of approximately 435 million Japanese Yen at fixed rates. The
Company has not designated the contracts as hedges and, accordingly, has
recorded the estimated change in the fair value of the contracts of $203,000 in
other income (expense).
In 2003, the Company wrote off the balance of its investment in RedStorm
Scientific Inc. ($279,000) as the Company deemed the decline in the estimated
fair value to be other than temporary.
Provision for Income Taxes. The Company's tax provision in 2004 was
$90,000; $60,000 related to continuing operations and $30,000 related to
discontinued operations. The provision consisted of state taxes of $18,000, U.S.
alternative minimum tax of $1,000, foreign taxes of $121,000 and deferred taxes
of ($50,000).
In 2003, the Company recorded an income tax provision of $119,000; $93,000
related to the continuing operations and $26,000 related to discontinued
operations. The provision is comprised of foreign and state income taxes. The
Company had a full valuation allowance on its deferred income tax assets.
Loss from Discontinued Operations, net of income taxes. In September 2003,
the Company completed the sale of substantially all of the assets of GSE Process
Solutions, Inc. (Process) to Novatech, LLC. (Novatech) pursuant to an Asset
Purchase Agreement, effective as of September 25, 2003, by and between the
Company, Process and Novatech. The operating results of the Company's Process
business prior to the sale have been classified as discontinued operations in
the Consolidated Statements of Operations.
For the year ended December 31, 2003, contract revenue for the discontinued
Process business was $13.7 million. Net loss for the discontinued Process
business in 2003 was $1.7 million.
Loss on Sale of Discontinued Operations, net of income taxes. In
conjunction with the Company's sale of its Process business in September 2003,
the Company received $5.5 million in cash, subject to certain adjustments and
recognized a loss of $262,000. In connection with the transaction, Novatech
purchased certain assets with a book value of $11.7 million and assumed certain
operating liabilities totaling approximately $6.8 million. The Company incurred
approximately $865,000 of closing costs associated with the transaction,
including a $100,000 accrual for possible post-closing claims from Novatech in
the twelve months following the sale, as outlined in various provisions of the
Asset Purchase Agreement. In the third quarter 2004, the Company reduced the
accrual by $66,000 to management's best estimate of the Company's exposure to
loss.
Liquidity and Capital Resources.
As of December 31, 2005, GSE had cash and cash equivalents of $1.3 million
versus $868,000 at December 31, 2004. After completion of the financing
transactions discussed below, the Company believes that it has sufficient
liquidity and working capital for its operations in 2006. However, if the
Company is unable to operate profitably and generate sufficient cash from
operations, the availability under its new line of credit may not be sufficient
and the Company may be required to look for additional capital to fund its
operations. There can be no assurance that the Company would be successful in
raising such additional funds.
Cash from operating activities. For the year ended December 31, 2005, net
cash used in operating activities was $1.9 million compared with $393,000 in
2004. The increase of of $1.5 million was primarily attributed to the change in
net loss of $4.8 million offset by significant changes in the Company's assets
and liabilities, which in 2005 include:
* A $1.8 decrease in contracts receivable. The decrease reflects the
combination of (a) a decrease in outstanding trade receivables of $1.0
million due to the lower project activity in 2005, (b) a decrease in
unbilled receivables of $560,000 due to the timing of contract
invoicing milestones, and (c) an increase in the bad debt reserve of
$220,000.
* An $810 decrease in prepaid expenses and other assets. The decrease
mainly reflects the following items: (a) the amortization of fees
incurred in 2004 related to the issuance of project advance payment
and performance bonds, (b) the reduction of an advance payment to a
subcontractor in 2004 as the subcontractor performed the related work,
and (c) the reduction in the fair value of the Company's hedging
contracts.
For the year ended December 31, 2004, net cash used in operating activities
was $393,000; $357,000 was used by continuing operations and $36,000 was used by
discontinued operations. Significant changes in the Company's assets and
liabilities in 2004 included:
* a $734,000 decrease in contracts receivable. The Company invoices
customers upon the completion of contract-specified milestones;
milestone billings were lower in the fourth quarter 2004 compared to
the fourth quarter 2003 due to lower contract activity.
* a $547,000 reduction in prepaid expenses and other assets. The
reduction reflects (1) lower prepaid insurance expense due to the
participation of the Company in some of GP Strategies' insurance
programs, (2) the collection from Novatech of expenses paid by the
Company on behalf of Novatech after the sale of the Process business
in 2003 and (3) amortization of capitalized bank commitment fees.
* an increase in accounts payable, accrued compensation and accrued
expenses of $200,000. The increase reflects the increase in project
activity in 2004 as compared to the prior year and the related
increase in obligations to the Company's subcontractors.
* a decrease in billings in excess of revenues earned by $2.8 million.
In 2003, the Company had entered into a $6.6 million contract with a
Mexican customer for a full scope simulator that allowed the Company
to invoice the customer for 20% of the contract upon the receipt of
the purchase order as an advance payment. The reduction in billings in
excess of revenues earned largely reflects the completion of work
which has reduced the Company's liability to the customer for the
advance payment.
Net cash provided by operating activities was $1.4 million for the year
ended December 31, 2003; $506,000 was provided by continuing operations and
$883,000 by discontinued operations. Significant changes in the assets and
liabilities of the Company in 2003 included:
* a $3.0 million increase in contracts receivable. This increase
reflects the higher revenue and backlog in 2003 and the completion of
significant billing milestones at year-end.
* a $624,000 increase in prepaid expenses and other assets. The increase
reflects an advance payment to a subcontractor by the Company on one
of its projects and fees incurred in the issuance of project advance
payment and performance bonds.
* a $2.1 million increase in accounts payable, accrued compensation and
accrued expenses. Due to the increased project activity in 2003,
purchases of materials and subcontractor labor are at a higher level.
* a $3.3 million increase in billings in excess of revenue earned. The
increase reflects the receipt of an advance payment of $1.3 million on
one project in 2003 and the timing of milestone billings on several
other projects.
Cash provided by (used in) investing activities. Net cash used in investing
activities was $692,000 for the year ended December 31, 2005. The Company made
capital expenditures of $182,000 and capitalized software development costs of
$483,000. Net cash used in investing activities was $110,000 for the year ended
December 31, 2004, consisting of $361,000 of capitalized software development
costs and $222,000 of capital expenditures, offset by the expiration of stand-by
letters of credit for which the $473,000 of cash collateral was released.
Standby letters of credit are issued by the Company in the ordinary course of
business through banks as required by certain contracts and proposal
requirements.
Net cash used in investing activities for the year ended December 31, 2003
was $3.7 million; $4.2 million provided by continuing operations and $506,000
used by discontinued operations.
The $3.7 million provided by continuing operations included $5.2 million
proceeds from the sale of the Process business unit, net of transaction costs,
offset by $515,000 in cash payments of contingent consideration for a prior year
acquisition, $191,000 of capital expenditures, and $542,000 of capitalized
software development costs. Additionally, $245,000 of cash collateralized
stand-by letters of credit expired, and the cash collateral was released.
Cash provided by (used in) financing activities. For the year ended
December 31, 2005, the Company generated $3.1 million in cash from financing
activities. The Company borrowed $1,182,000 from its bank line of credit,
generated $100,000 from the exercise of employee stock options, and issued to
Dolphin Direct Equity Partners, LP a Senior Subordinated Secured Convertible
Note in the aggregate principle amount fo $2,000,000. The Company incurred
$197,000 of deferred financing costs related to the Dolphin Note and paid down a
note payable of $9,000.
For the year ended December 31, 2004, the Company used $33,000 in financing
activities related to the pay down of a note payable.
For the year ended December 31, 2003, cash used in financing activities was
$5.5 million, all of which was used in the continuing operations. The Company
decreased its borrowings under its bank line of credit by $5.4 million from the
proceeds received from the sale of the Process business.
Credit Facilities.
Prior to March 7, 2006 and as of December 31, 2005, the Company had a $1.5
million credit facility through General Physics Corporation, a wholly owned
subsidiary of GP Strategies. The line was collateralized by substantially all of
the Company's assets and provided for borrowings up to 80% of eligible accounts
receivable and 80% of eligible unbilled receivables. GP Strategies guaranteed
the borrowings. The interest rate on this line of credit was based upon the
Daily LIBOR Market Index Rate plus 3% (7.38% as of December 31, 2005), with
interest only payments due monthly. As of December 31, 2005, the Company's
outstanding borrowings were $1,182,000 which were repaid on March 7, 2006.
On March 7, 2006, the Company entered into a new loan and security
agreement with Laurus Master Fund, Ltd. The new agreement established a $5.0
million line of credit for the Company. The line is collateralized by
substantially all of the Company's assets and provides for borrowings up to 90%
of eligible accounts receivable, and 40% of eligible unbilled receivables (up to
a maximum of $1.0 million). The interest rate on this line of credit is based on
the prime rate plus 200-basis points, with interest only payments due monthly.
There are no financial covenant requirements under the new agreement.
The Company issued to Laurus Master Fund, Ltd. a warrant to purchase up to
367,647 shares of GSE common stock at an exercise price of $.01 per share.
The Company borrowed $747,000 on March 8, 2006. Availability under the new
agreement on that date was $1.6 million.
Senior Convertible Secured Subordinated Note Payable
On May 26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP
a Senior Subordinated Secured Convertible Note in the aggregate principal amount
of $2,000,000, which matures March 31, 2009 (the "Dolphin Note"), and a
seven-year warrant to purchase 380,952 shares of GSE common stock at an exercise
price of $2.22 per share (the "GSE Warrant"). The Dolphin Note is convertible
into 1,038,961 shares of GSE common stock at a conversion price of $1.925 per
share and accrues interest at 8% payable quarterly. Both the convertible note
and the warrant are subject to anti-dilution provisions. The aggregate purchase
price for the Dolphin Note and GSE Warrant was $2,000,000. At the date of
issuance, the fair value of the GSE Warrant was $375,000 and the fair value of
the Conversion Option of the Dolphin Note was $959,000, both of which were
recorded as noncurrent liabilities, with the offset recorded as original issue
discount (OID). OID is accreted over the term of the Dolphin Note and charged to
interest expense, and the unamortized balance is netted against long-term debt
in the accompanying consolidated balance sheets. The GSE Warrant and Conversion
Option liabilities are marked to market through earnings on a quarterly basis in
accordance with EITF NO. 00-19, Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in a Company's Common Stock. For the year
ended December 31, 2005, the Company recognized a gain of $636,000 from the
change in the fair value of these liabilities. The gain is recorded in other
income (expense), net.
On February 28, 2006, the Company and Dolphin entered into a Cancellation
and Warrant Exchange Agreement (the "Cancellation Agreement" ) under which
Dolphin agreed to cancel its Senior Subordinated Secured Convertible Promissory
Note and cancel its outstanding warrant to purchase 380,952 shares of GSE common
stock at an exercise price of $2.22 per share. In exchange for Dolphin's
agreement to enter into the Cancellation Agreement and for the participation of
Dolphin Offshore Partners, LP in the Preferred Stock transaction discussed
below, the Company paid off the Dolphin Note and agreed to issue a new warrant
to purchase 900,000 shares of GSE common stock at an exercise price of $.67 per
share. Dolphin must exercise the new warrant promptly after the Company
certifies to Dolphin on or after May 30, 2006 (the "Mandatory Exercise Date")
that, among other things, the current stock price shall not be less than $1.25
on the Mandatory Exercise Date and that the average of the current stock prices
for each trading day of the 30 calendar day period up to and including the
Mandatory Exercise Date is not less than $1.25.
Series A Cumulative Preferred Stock
On February 28, 2006, the Company raised $4.25 million through the sale of
42,500 shares of Series A Cumulative Convertible Preferred Stock and Warrants by
means of a private placement to "accredited investors", as that term is used in
rules and regulations of the Securities and Exchange Commission. The Convertible
Preferred Stock is convertible at any time into a total of 2,401,130 shares of
GSE common stock at a conversion price of $1.77 per share. The conversion price
was equal to 110% of the closing price of the Company's Common Stock on February
28, 2006, the date the sale of the Convertible Preferred Stock was completed.
Each investor received a five-year warrant to purchase GSE common stock equal to
20% of the shares they would receive from the conversion of the Convertible
Preferred Stock, at an exercise price of $1.77. In aggregate, the Company issued
warrants to purchase a total of 480,226 shares of GSE common stock. The
Convertible Preferred Stock holders are entitled to an 8% cumulative dividend,
payable on a semiannual basis every June 30 and December 30. If the Company does
not make two consecutive dividend payments on the dates such payments are due,
there will be an additional 30% warrant coverage of five-year warrants at a
conversion price of $1.77 per share. At any time after March 1, 2007, the
Company has the right to convert the Preferred Stock into shares of GSE common
stock when the average of the current stock price during the twenty trading days
immediately prior to the date of such conversion exceeds 200% of the Series A
Conversion Price. The holders of the Convertible Preferred Stock are entitled to
vote on all matters submitted to the stockholders for a vote, together with the
holders of the voting common stock, all voting together as a single class. The
holders of the Convertible Preferred Stock are entitled to the number of votes
equal to the number of GSE common stock that they would receive upon conversion
of their Convertible Preferred Stock.
The Company paid the placement agent 6% of the gross proceeds received by
the Company from the offering ($255,000) plus five-year warrants to purchase
150,000 shares of the Company's common stock at an exercise price of $1.77 per
share.
The proceeds were used to payoff the Dolphin Note and the Company's line of
credit balance and for other working capital purposes.
Contractual Cash Commitments
The following summarizes the Company's contractual cash obligations as of
December 31, 2005, and the effect these obligations are expected to have on its
liquidity and cash flow in future periods:
- --------------------------------------------------------------------------------------------------------
Payments Due by Period
(in thousands)
- --------------------------------------------------------------------------------------------------------
Contractual Cash
Obligations Total Less than 1-3 Years 4-5 Years After 5
1 year Years
- --------------------------------------------------------------------------------------------------------
Long Term Debt (1) $ 3,182 $ 1,182 $ 2,000 $ - $ -
- --------------------------------------------------------------------------------------------------------
Subcontractor and
Purchase Commitments $ 2,176 $ 2,083 $ 93 $ - $ -
- --------------------------------------------------------------------------------------------------------
Net future minimum
lease payments $ 2,396 $ 1,165 $ 1,231 $ - $ -
- --------------------------------------------------------------------------------------------------------
Total $ 7,754 $ 4,430 $ 3,324 $ - $ -
- --------------------------------------------------------------------------------------------------------
(1) On February 28, 2006, the Company raised $4.25 million through the sale
of 42,500 shares of Series A Cumulative Convertible Preferred Stock and
Warrants by means of a private placement to "accredited investors", as that
term is used in rules and regulations of the Securities and Exchange
Commission. The proceeds were used to pay off the $2.0 million Dolphin Note
and the Company's $1.2 million line of credit balance and for other working
capital purposes. The Convertible Preferred Stock holders are entitled to
an 8% cumulative dividend, payable on a semiannual basis every June 30 and
December 30. If the Company does not make two consecutive dividend payments
on the dates such payments are due, there will be an additional 30% warrant
coverage of five-year warrants at a conversion price of $1.77 per share.
In October 2005, the Company signed an "Assignment of Lease and Amendment
to Lease" that assigns and transfers to another tenant (the "assignee") the
Company's rights, title and interest in its Columbia, Maryland facility lease.
The assignee's obligation to pay rent under the Lease began on February 1, 2006.
The Company remains fully liable for the payment of all rent and for the
performance of all obligations under the lease through the scheduled expiration
of the lease, May 31, 2008, should the assignee default on their obligations.
As of December 31, 2005, the Company was contingently liable for two
letters of credit totaling $66,000. The letters of credit represent payment
bonds on two contracts and have been cash collateralized. In addition, the
Company was contingently liable at December 31, 2005 for approximately $30,000
under a performance bond on one contract which was secured by a bank guarantee
of the Company's foreign subsidiary.
Foreign Exchange.
A portion of the Company's international sales revenue has been and may be
received in a currency other than the currency in which the expenses relating to
such revenue are paid. When necessary, the Company enters into forward exchange
contracts, options and swap agreements as hedges against certain foreign
currency commitments to hedge its foreign currency risk.
Off-balance Sheet Obligations.
The Company has no off-balance sheet obligations as of December 31, 2005,
except for its operating lease commitments and outstanding letters of credit.
See Contractual Cash Commitments above.
New Accounting Standards.
In December 2004, the FASB issued SFAS No. 123R which revises SFAS No. 123
and supersedes APB No. 25. Currently, the Company does not record compensation
expense for certain stock-based compensation. Under SFAS No. 123R, the Company
will measure the cost of employee services received in exchange for stock, based
on the grant-date fair value with limited exceptions) of the stock award. Such
cost will be recognized over the period during which the employee is required to
provide service in exchange for the stock award (usually the vesting period).
The fair value of the stock award will be estimated using an option-pricing
model, with excess tax benefits, as defined in SFAS No. 123R, being recognized
as an adjustment to additional paid-in capital. The Company adopted SFAS No.
123R on January 1, 2006 using the Modified Prospective Application method
without restatement of prior periods. Under this method, the Company recognizes
compensation cost for the unvested fair value of its outstanding awards as of
Janua ry 1, 2006. Compensation cost for these awards will be based on the fair
value of the awards as disclosed on a pro forma basis under SFAS No. 123. The
Company will account for awards that are granted, modified, or settled after the
adoption date in accordance with SFAS No. 123R.
At December 31, 2005, all of the Company's outstanding options are fully
vested and thus there will be no compensation expense in 2006 related to the
adoption of SFAS No. 123R. The Company has not yet developed an estimate of
compensation expense related to future grants of stock options, which would
result in additional expense under SFAS No. 123R.
Other Matters.
To date, management believes inflation has not had a material impact on the
Company's operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company's market risk is principally confined to changes in foreign
currency exchange rates. During the year ended December 31, 2005, 14% of the
Company's revenue was from contracts which required payments in a currency other
than U.S. Dollars, principally Swedish Krona (6%) and Japanese Yen (8%). For the
year ended December 31, 2004, 3% and 13% of the Company's revenue was
denominated in Swedish Krona and Japanese Yen, respectively. In addition, during
the years ended December 31, 2005 and 2004, 13% and 16%, respectively, of the
Company's expenses were incurred in Swedish Krona. The Company's exposure to
foreign exchange rate fluctuations arises in part from inter-company accounts in
which costs incurred in one entity are charged to other entities in different
foreign jurisdictions. The Company is also exposed to foreign exchange rate
fluctuations as the financial results of all foreign subsidiaries are translated
into U.S. dollars in consolidation. As exchange rates vary, those results when
tra nslated may vary from expectations and adversely impact overall expected
profitability.
The Company utilizes forward foreign currency financial instruments to
manage market risks associated with the fluctuations in foreign currency
exchange rates. It is the Company's policy to use derivative financial
instruments to protect against market risk arising in the normal course of
business. The criteria the Company uses for designating an instrument as a hedge
include the instrument's effectiveness in risk reduction and one-to-one matching
of derivative instruments to underlying transactions. The Company monitors its
foreign currency exposures to maximize the overall effectiveness of its foreign
currency hedge positions. The principal currency hedged is the Japanese yen. The
Company's objectives for holding derivatives are to minimize the risks using the
most effective methods to reduce the impact of these exposures. The Company
minimizes credit exposure by limiting counterparties to nationally recognized
financial institutions.
As of December 31, 2005, the Company had contracts for the sale of
approximately 247 million Japanese Yen at fixed rates. The contracts expire on
various dates through May 2007. The Company has not designated the contracts as
hedges and, accordingly, has recorded the estimated fair value of the contracts
of $31,000 as of December 31, 2005. The Company recognized unrealized gains
(losses) of approximately ($170,000) and $203,000 in 2005 and 2004,
respectively, on these contracts.
The Company is also subject to market risk related to the interest rate on
its existing line of credit. As of December 31, 2005, such interest rate is
based on the Daily Libor Market Index Rate plus 300 basis-points. A 100
basis-point change in such rate during the year ended December 31, 2005 would
have increased (decreased) the Company's annual interest expense by
approximately $8,000.
On May 26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP
a Senior Subordinated Secured Convertible Note in the aggregate principle amount
of $2,000,000, which matures March 31, 2009, and a seven-year warrant to
purchase 380,952 shares of GSE common stock at an exercise price of $2.22 per
share. The Dolphin Note is convertible into 1,038,961 shares of GSE common stock
at a conversion price of $1.925 per share and accrues interest at 8% payable
quarterly. Both the convertible note and the warrant are subject to
anti-dilution provisions. The aggregate purchase price for the Dolphin Note and
GSE Warrant was $2,000,000. At the date of issuance, the fair value of the GSE
Warrant was $375,000 and the fair value of the Conversion Option of the Dolphin
Note was $959,000, both of which were recorded as noncurrent liabilities, with
the offset recorded as original issue discount (OID). The GSE Warrant and
Conversion Option liabilities are marked to market through earnings on a
quarterly basis in accordance with EITF No. 00-19, Accounting for Derivative
Financial Insturments Indexed to, and Potentially Settled in a Company's Common
Stock. For the year ended December 31, 2005, the Company recognized a gain of
$636,000 from the change in fair market value of these liabilities from the date
of issue to December 31, 2005. The closing price of the Company's common stock
on December 31, 2005 as reported by the American Stock Exchange was $1.24 per
share. If the closing price had been $1.34 or $1.14 at December 31, 2005, the
gain recognized by the Company from the change in fair market value of these
liabilities would have been $549,000 and $738,0000, respectively.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
INDEX TO FINANCIAL STATEMENTS
Page
GSE Systems, Inc. and Subsidiaries
Report of Independent Registered Public Accounting Firm....................F-1
Consolidated Balance Sheets as of December 31, 2005 and 2004...............F-2
Consolidated Statements of Operations for the years ended
December 31, 2005, 2004, and 2003....................................F-3
Consolidated Statements of Comprehensive Income (Loss) for the years
ended December 31, 2005, 2004, and 2003..............................F-4
Consolidated Statements of Changes in Stockholders' Equity for the years
ended December 31, 2005, 2004, and 2003..............................F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 2005, 2004, and 2003....................................F-6
Notes to Consolidated Financial Statements.................................F-7
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
GSE Systems, Inc.:
We have audited the accompanying consolidated balance sheets of GSE
Systems, Inc. and subsidiaries as of December 31, 2005 and 2004, and the
related consolidated statements of operations, comprehensive income (loss),
changes in stockholders' equity and cash flows for each of the years in the
three-year period ended December 31, 2005. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of GSE
Systems, Inc. and subsidiaries as of December 31, 2005 and 2004, and the
results of their operations and their cash flows for each of the years in
the three-year period ended December 31, 2005 in conformity with U.S.
generally accepted accounting principles.
/s/ KPMG LLP
Baltimore, Maryland
March 29, 2006
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
December 31,
----------------------------
2005 2004
------------- -------------
ASSETS
Current assets:
Cash and cash equivalents $ 1,321 $ 868
Restricted cash - 29
Contract receivables 6,896 8,723
Prepaid expenses and other current assets 376 819
------------- -------------
Total current assets 8,593 10,439
Equipment and leasehold improvements, net 329 596
Software development costs, net 940 909
Goodwill, net 1,739 1,739
Other assets 381 545
------------- -------------
Total assets $ 11,982 $ 14,228
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt $ 1,182 $ 9
Accounts payable 3,019 2,998
Due to GP Strategies Corporation 542 291
Accrued expenses 1,612 1,608
Accrued compensation and payroll taxes 1,226 1,523
Billings in excess of revenue earned 1,177 1,079
Accrued warranty 754 667
Other current liabilities 6 89
------------- -------------
Total current liabilities 9,518 8,264
Long-term debt 869 -
Other liabilities 698 19
------------- -------------
Total liabilities 11,085 8,283
------------- -------------
Commitments and contingencies
Stockholders' equity:
Preferred stock $.01 par value, 2,000,000 shares authorized, no shares issued and
outstanding - -
Common stock $.01 par value, 18,000,000 shares authorized, shares issued and
outstanding 8,999,706 in 2005 and 8,949,706 in 2004 90 89
Additional paid-in capital 30,915 30,815
Accumulated deficit - at formation (5,112) (5,112)
Accumulated deficit - since formation (23,839) (19,044)
Accumulated other comprehensive loss (1,157) (803)
------------- -------------
Total stockholders' equity 897 5,945
------------- -------------
Total liabilities and stockholders' equity $ 11,982 $ 14,228
============= =============
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
Years ended December 31,
------------------------------------------
2005 2004 2003
------------- ------------ ------------
Contract revenue $ 21,950 $29,514 $25,019
Cost of revenue 18,603 22,715 19,175
------------- ------------ ------------
Gross profit 3,347 6,799 5,844
------------- ------------ ------------
Operating expenses
Selling, general and administrative 6,958 5,543 6,343
Administrative charges from GP Strategies 685 974 100
Depreciation and amortization 431 280 392
------------- ------------ ------------
Total operating expenses 8,074 6,797 6,835
------------- ------------ ------------
Operating income (loss) (4,727) 2 (991)
Interest expense, net (416) (176) (504)
Other income (expense), net 497 316 (273)
------------- ------------ ------------
Income (loss) from continuing operations before income taxes (4,646) 142 (1,768)
Provision for income taxes 149 60 93
------------- ------------ ------------
Income (loss) from continuing operations (4,795) 82 (1,861)
------------- ------------ ------------
Loss from discontinued operations, net of income taxes - - (1,409)
Income (loss) on sale of discontinued operations, net
of income taxes - 36 (262)
------------- ------------ ------------
Income (loss) from discontinued operations - 36 (1,671)
------------- ------------ ------------
Net income (loss) (4,795) 118 (3,532)
Preferred stock dividends and beneficial conversion premium - - (2,140)
------------- ------------ ------------
Net income (loss) attributed to common shareholders $ (4,795) $ 118 $ (5,672)
============= ============ ============
Basic income (loss) per common share:
Continuing operations $ (0.53) $ 0.01 $ (0.61)
Discontinued operations - - (0.26)
------------- ------------ ------------
Net income (loss) $ (0.53) $ 0.01 $ (0.87)
============= ============ ============
Diluted income (loss) per common share
Continuing operations $ (0.53) $ 0.01 $ (0.61)
Discontinued operations - - (0.26)
------------- ------------ ------------
Net income (loss) $ (0.53) $ 0.01 $ (0.87)
============= ============ ============
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
Years ended December 31,
-------------------------------------------
2005 2004 2003
------------- -------------- ------------
Net income (loss) $ (4,795) $ 118 $ (3,532)
Foreign currency translation adjustment (354) 148 236
------------- -------------- ------------
Comprehensive income (loss) $ (5,149) $ 266 $ (3,296)
============= ============== ============
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC, AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands)
Preferred Common Accumulated Deficit Accumulated
Stock Stock Additional ------------------------ Other
--------------------- ----------------- Paid-in At Since Comprehensive
Shares Amount Shares Amount Capital Formation Formation Loss Total
--------- -------- -------- ------- ----------- ---------- ----------- ------------ ----------
Balance, January 1, 2003 39 $ - 5,870 $ 59 $ 27,841 $ (5,112) $ (13,490) $ (1,187) $ 8,111
Common stock issued to GP
Strategies Corporation - - 150 1 179 - - - 180
Fair value of warrants issued
to non-employees - - - - 86 - - - 86
Preferred stock dividends
declared and payable - - - - - - (190) - (190)
Stock dividend issued due
to change in preferred
stock conversion price - - 1,037 10 1,940 - (1,950) - -
Conversion of preferred
stock to common stock (39) - 1,474 15 (14) - - - 1
Conversion of subordinated
debt to common stock - - 419 4 783 - - - 787
Foreign currency translation
adjustment - - - - - - - 236 236
Net loss - - - - - - (3,532) - (3,532)
--------- -------- -------- ------- ----------- ---------- ----------- ------------ ----------
Balance, December 31, 2003 - - 8,950 89 30,815 (5,112) (19,162) (951) 5,679
Foreign currency translation
adjustment - - - - - - - 148 148
Net income - - - - - - 118 - 118
--------- -------- -------- ------- ----------- ---------- ----------- ------------ ----------
Balance, December 31, 2004 - - 8,950 89 30,815 (5,112) (19,044) (803) 5,945
Common stock issued for
options exercised - - 50 1 100 - - - 101
Foreign currency translation
adjustment - - - - - - - (354) (354)
Net loss - - - - - - (4,795) - (4,795)
--------- -------- -------- ------- ----------- ---------- ----------- ------------ ----------
Balance, December 31, 2005 - $ - 9,000 $ 90 $ 30,915 $ (5,112) $ (23,839) $ (1,157) $ 897
========= ========= ======== ======= =========== ========== =========== ============ ==========
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Years ended December 31,
------------------------------------------
2005 2004 2003
------------ ------------- ------------
Cash flows from operating activities:
Net income (loss) $ (4,795) $ 118 $ (3,532)
Loss from discontinued operations - - (1,409)
Income (loss) on sale of discontinued operations - 36 (262)
------------ ------------- ------------
Income (loss) from continuing operations (4,795) 82 (1,861)
Adjustments to reconcile income (loss) from continuing operations to
net cash provided by (used in) operating activities:
Depreciation and amortization 1,121 678 731
Change in fair market value of liabilities for conversion option and warrants (636) - -
Foreign currency transaction (gain) loss 35 (52) (5)
Deferred income taxes 50 (50) -
Changes in assets and liabilities:
Contract receivables 1,827 734 (3,010)
Prepaid expenses and other assets 810 547 (624)
Accounts payable, accrued compensation and accrued expenses (597) 200 2,060
Due to GP Strategies Corporation 251 191 100
Billings in excess of revenue earned 79 (2,829) 3,335
Accrued warranty reserves 87 158 (158)
Other liabilities (25) (50) (26)
Income taxes payable (58) 34 (36)
------------ ------------- ------------
Net cash provided by (used in) continuing operations (1,851) (357) 506
Net cash provided by (used in) discontinued operations - (36) 883
------------ ------------- ------------
Net cash provided by (used in) operating activities (1,851) (393) 1,389
------------ ------------- ------------
Cash flows from investing activities:
Proceeds from sale of Process business, net of transaction costs - - 5,245
Net cash paid for acquisition of businesses - - (515)
Capital expenditures (182) (222) (191)
Capitalized software development costs (483) (361) (542)
Releases (restrictions) of cash as collateral under letters of credit, net (27) 473 245
Other cash used in discontinued operations, net - - (506)
------------ ------------- ------------
Net cash provided by (used in) investing activities (692) (110) 3,736
------------ ------------- ------------
Cash flows from financing activities:
Proceeds from issuance of common stock 100 - -
Increase (decrease) in borrowings under line of credit 1,182 - (5,431)
Issuance of subordinated convertible note payable 2,000 - -
Deferred financing costs (232) - -
Other financing repayments (9) (33) (30)
------------ ------------- ------------
Net cash provided by (used in) financing activities 3,041 (33) (5,461)
------------ ------------- ------------
Effect of exchange rate changes on cash (45) 16 107
------------ ------------- ------------
Net increase (decrease) in cash and cash equivalents 453 (520) (229)
Cash and cash equivalents at beginning of year 868 1,388 1,617
------------ ------------- ------------
Cash and cash equivalents at end of year $ 1,321 $ 868 $ 1,388
============ ============= ============
The accompanying notes are an integral part of these consolidated financial statements.
1. Business and basis of presentation
GSE Systems, Inc. ("GSE Systems", "GSE" or the "Company") develops and
delivers business and technology solutions by applying simulation software,
systems and services to the energy industry worldwide.
On June 21, 2005, the Board of Directors of GP Strategies Corporation ("GP
Strategies") approved plans to spin-off its 57% interest in GSE through a
special dividend to the GP Strategies' stockholders. On September 30, 2005, the
GP Strategies' stockholders received 0.283075 share of GSE common stock for each
share of GP Strategies common stock or Class B stock held on the record date of
September 19, 2005. Following the spin-off, GP Strategies ceased to have any
ownership interest in GSE. GP Strategies will continue to provide corporate
support services to GSE, including accounting, finance, human resources, legal,
network support and tax pursuant to a Management Services Agreement which
expires on December 31, 2006.
The Company's operations are subject to certain risks and uncertainties
including, among others, rapid technological changes, success of the Company's
product development, marketing and distribution strategies, the need to manage
growth, the need to retain key personnel and protect intellectual property, and
the availability of additional financing on terms acceptable to the Company.
In September 2003, the Company completed the sale of substantially all of
the assets of GSE Process Solutions, Inc. (Process) to Novatech, LLC (Novatech)
pursuant to an Asset Purchase Agreement, effective as of September 25, 2003. The
operating results of the Company's Process business have been classified as
discontinued operations in the Consolidated Statements of Operations for all
periods presented.
In 2005, the Company incurred a significant operating loss. The Company's
revenue and profitability were impacted by the low volume of orders logged in
2004 and 2005 and the Company's cash position weakened during the year, with
total cash used in operating activities of $1.9 million. After the completion of
the financing transactions discussed in Note 19 Subsequent events, the Company
believes that it has sufficient liquidity and working capital for its operations
in 2006. However, if the Company is unable to generate sufficient cash from
operations, the availability under its new line of credit may not be sufficient
and the Company may be required to look for additional capital to fund its
operations. There can be no assurance that the Company would be successful in
raising such additional funds.
2. Summary of significant accounting policies
Principles of consolidation
The accompanying consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiaries. All intercompany balances and
transactions have been eliminated.
Accounting estimates
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 affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. The Company's most significant estimates
relate to revenue recognition, capitalization of software development costs, and
the recoverability of deferred tax assets. Actual results could differ from
those estimates.
Revenue recognition
The majority of the Company's revenue is derived through the sale of
uniquely designed systems containing hardware, software and other materials
under fixed-price contracts. In accordance with Statement of Position 81-1
Accounting for Performance of Construction-Type and Certain Production-Type
Contracts, the revenue under these fixed-price contracts is accounted for on the
percentage-of-completion method. This methodology recognizes revenue and
earnings as work progresses on the contract and is based on an estimate of the
revenue and earnings earned to date, less amounts recognized in prior periods.
The Company bases its estimate of the degree of completion of the contract by
reviewing the relationship of costs incurred to date to the expected total costs
that will be incurred on the project. Estimated contract earnings are reviewed
and revised periodically as the work progresses, and the cumulative effect of
any change in estimate is recognized in the period in which the change is
identified. Estima ted losses are charged against earnings in the period such
losses are identified. The Company recognizes revenue arising from contract
claims either as income or as an offset against a potential loss only when the
amount of the claim can be estimated reliably and realization is probable and
there is a legal basis of the claim. The Company has an outstanding claim with a
customer for work performed through December 31, 2005 of approximately
$265,000, for which $120,000 has been recognized in 2005.
As the Company recognizes revenue under the percentage-of-completion
method, it provides an accrual for estimated future warranty costs based on
historical and projected claims experience. The Company's long-term contracts
generally provide for a one-year warranty on parts, labor and any bug fixes as
it relates to software embedded in the systems.
The Company's system design contracts do not provide for "post customer
support service" (PCS) in terms of software upgrades, software enhancements or
telephone support. In order to obtain PCS, the customers must purchase a
separate contract. Such PCS arrangements are generally for a one-year period
renewable annually and include customer support, unspecified software upgrades,
and maintenance releases. The Company recognizes revenue from these contracts
ratably over the life of the agreements in accordance with Statement of Position
97-2 Software Revenue Recognition.
Revenue from the sale of software licenses which do not require significant
modifications or customization for the Company's modeling tools are recognized
when the license agreement is signed, the license fee is fixed and determinable,
delivery has occurred, and collection is considered probable.
Revenues from certain consulting or training contracts are recognized on a
time-and-material basis. For time-and-material type contracts, revenue is
recognized based on hours incurred at a contracted labor rate plus expenses.
Cash and cash equivalents
Cash and cash equivalents consist of cash on hand and overnight sweep
investments with maturities of three months or less at the date of purchase.
Contract Receivables
Contract receivables include recoverable costs and accrued profit not
billed which represents revenue recognized in excess of amounts billed. The
liability, "Billings in excess of revenue earned," represents billings in excess
of revenue recognized.
Billed receivables are recorded at invoiced amounts. The allowance for
doubtful accounts is based on historical trends of past due accounts,
write-offs, and specific identification and review of past due accounts. The
activity in the allowance for doubtful accounts is as follows:
(in thousands)
For the years ended December 31,
----------------------------------------------
2005 2004 2003
------------ ------------ ------------
Beginning balance $ 24 $ 7 $ 35
Current year provision 496 35 21
Current year write-offs (275) (18) (49)
------------ ------------ ------------
Ending balance $ 245 $ 24 $ 7
============ ============ ============
Equipment and leasehold improvements, net
Equipment is recorded at cost and depreciated using the straight-line
method with estimated useful lives ranging from three to ten years. Leasehold
improvements are amortized over the life of the lease or the estimated useful
life, whichever is shorter, using the straight-line method. Upon sale or
retirement, the cost and related amortization are eliminated from the respective
accounts and any resulting gain or loss is included in operations. Maintenance
and repairs are charged to expense as incurred.
Software development costs
Certain computer software development costs are capitalized in the
accompanying consolidated balance sheets in accordance with SFAS No. 86,
Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise
Marketed. Capitalization of computer software development costs begins upon the
establishment of technological feasibility. Capitalization ceases and
amortization of capitalized costs begins when the software product is
commercially available for general release to customers. Amortization of
capitalized computer software development costs is included in cost of revenue
and is provided using the straight-line method over the remaining estimated
economic life of the product, not to exceed five years.
Development expenditures
Development expenditures incurred to meet customer specifications under
contracts are charged to contract costs. Company sponsored development
expenditures are charged to operations as incurred and are included in selling,
general and administrative expenses. The amounts incurred for Company sponsored
development activities relating to the development of new products and services
or the improvement of existing products and services, were approximately
$758,000, $552,000, and $856,000, for the years ended December 31, 2005, 2004
and 2003, respectively. Certain of these expenditures were capitalized as
software development costs. See Note 7, Software development costs.
Impairment of Long-Lived Assets
In accordance with SFAS No. 144, Accounting for the Impairment or Disposal
of Lond-Lived Assets, property and equiptment are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. Recovery of assets to be held and used is
measured by a comparison of the carrying amount of an asset to estimated
undiscounted future cash flows, an impairment charge is recognized by the amount
by which the carrying amount of the asset exceeds the fair value of the asset.
Assets to be disposed of would be separately presented in the balance sheet and
reported at the lower of the carrying amount or fair value less costs to sell,
and are no longer depreciated. The assets and liabilities of a disposal group
classified as held for sale would be presented separately in the appropriate
asset and liability sections of the balance sheet.
Goodwill is tested annually, on November 30, for impairment, or more
frequently if events and circumstances indicate that the asset might be
impaired. An impairment loss is recognized to the extent that the carrying
amount exceeds the asset's fair value. For goodwill, the impairment
determination is made at the reporting unit level and consists of two steps.
First, the Company determines the fair value of a reporting unit and compares it
to its carrying amount. Second, if the carrying amount of a reporting unit
exceeds its fair value, an impairment loss is recognized for any excess of the
carrying amount of the goodwill. The implied fair value of goodwill is
determined by allocating the fair value of the reporting unit in a manner
similar to a purchase price allocation, in accordance with SFAS No. 141,
Business Combinations. The residual fair value after this allocation is the
implied fair value of the reporting unit goodwill. No impairment losses were
recognized in 2005, 2004, and 2003.
Foreign currency translation
Balance sheet accounts for foreign operations are translated at the
exchange rate at the balance sheet date, and income statement accounts are
translated at the average exchange rate for the period. The resulting
translation adjustments are included in other comprehensive income (loss).
Transaction gains and losses, resulting from changes in exchange rates, are
included in other income (expense) in the Consolidated Statements of Operations
in the period in which they occur. For the years ended December 31, 2005, 2004,
and 2003, foreign currency transaction gains (losses) were approximately
($35,000), $52,000, and $5,000, respectively.
Warranty
As the Company recognizes revenue under the percentage of-completion
method, it provides an accrual for estimated future warranty costs based on
historical experience and projected claims. The activity in the warranty
accounts is as follows:
(in thousands) As of and for the
Years ended December 31,
------------------------------------------------------------------
2005 2004 2003
-------------------- --------------------- ------------------
Beginning balance $ 667 $ 509 $ 667
Current year provision 286 312 470
Current year claims (166) (154) (628)
Currency adjustment (33) - -
-------------------- --------------------- ------------------
Ending balance $ 754 $ 667 $ 509
==================== ===================== ==================
Income taxes
Deferred income taxes are provided under the asset and liability method.
Under this method, deferred income taxes are determined based on the differences
between the financial statement and tax bases of assets and liabilities using
enacted tax rates in effect for the year in which the differences are expected
to reverse. Valuation allowances are established when necessary to reduce
deferred tax assets to the amounts expected to be realized. Provision is made
for the Company's current liability for federal, state and foreign income taxes
and the change in the Company's deferred income tax assets and liabilities. No
provision has been made for the undistributed earnings of the Company's foreign
subsidiaries as they are considered permanently invested. Amounts of
undistributed earnings are not material to the overall consolidated financial
statements.
Stock Compensation
The Company applies the intrinsic-value-based method of accounting
prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for
stock issued to Employees, and related interpretations including FASB
Interpretation No. 44, Accounting for Certain Transactions involving Stock
Compensation, and interpretation of APB Opinion No. 25, issued in March 2000, to
account for its fixed-plan stock options. Under this method, compensation
expense is recorded on the date of grant only if the current market price of the
underlying stock exceeds the exercise price. SFAS No. 123, Accounting for
Stock-Based Compensation, established accounting and disclosure requirements
using a fair-value-based method of accounting for stock based employee
compensation plans. As allowed by SFAS No. 123, the Company has elected to
continue to apply the intrinsic-value-based method of accounting describe above,
and has adopted only the disclosure requirements of SFAS No. 123.
If the computed values of all the Company's stock based awards were
calculated and expensed (over the vesting period of the awards) using the fair
value method specified under SFAS 123, net income (loss) would have been as
follows:
(in thousands, except per share data)
Years ended December 31,
-----------------------------------------------------
2005 2004 2003
---------------- ----------------- ----------------
Net income (loss) attributed to
common stockholders, as reported $ (4,795) $ 118 $ (5,672)
Add stock-based employee compensation expense
included in reported net income (loss), net of tax - - -
Deduct total stock-based employee compensation
expense determined under fair-value-method
for all awards, net of tax (672) (51) (381)
---------------- ----------------- ----------------
Proforma net income (loss) $ (5,467) $ 67 $ (6,053)
================ ================= ================
Net income (loss) per share, as reported:
Basic $ (0.53) $ 0.01 $ (0.87)
Diluted $ (0.53) $ 0.01 $ (0.87)
Proforma net income (loss) per share:
Basic $ (0.61) $ 0.01 $ (0.93)
Diluted $ (0.61) $ 0.01 $ (0.93)
Options with an average exercise price of $1.85 covering a total of 600,000
shares of common stock were granted to 47 employees in March 2005, all of which
vested immediately. No employee stock options were issued in 2004 or 2003.
The fair value of each option granted in 2005 was estimated on the date of
grant using a Black-Scholes option-pricing model with the following
weighted-average assumptions:
Risk-free interest rate 4.0%
Dividend yield 0.0%
Expected life 4.4
Volatility 74.6%
Income (loss) per share
Basic income (loss) per share is based on the weighted average number of
outstanding common shares for the period. Diluted income (loss) per share
adjusts the weighted average shares outstanding for the potential dilution that
could occur if stock options, warrants, convertible subordinated debt or
convertible preferred stock were exercised or converted into common stock. The
number of common shares and common share equivalents used in the determination
of basic and diluted income (loss) per share was as follows:
(in thousands, except for share and per share amounts)
Years ended December 31,
2005 2004 2003
------------------ ----------------- -----------------
Numerator:
Net income (loss) $ (4,795) $ 118 $ (3,532)
Stock dividend- beneficial conversion premium - - (1,950)
Preferred stock dividends - - (190)
------------------ ----------------- -----------------
Net income (loss) attributed to
common stockholders $ (4,795) $ 118 $ (5,672)
================== ================= =================
Denominator:
Weighted-average shares outstanding for basic
earnings per share 8,999,021 8,949,706 6,542,000
Effect of dilutive securities:
Employee stock options, warrants and
options outside the plan - 105,736 -
------------------ ----------------- -----------------
Adjusted weighted-average shares outstanding
and assumed conversions for diluted
earnings per share 8,999,021 9,055,442 6,542,000
================== ================= =================
Shares related to dilutive securities excluded
because inclusion would be anti-dilutive: 2,753,213 1,294,826 1,903,976
================== ================= =================
Basic income (loss) per common share:
Continuing operations $ (0.53) $ 0.01 $ (0.61)
Discontinued operations - - (0.26)
------------------ ----------------- -----------------
Net income (loss) $ (0.53) $ 0.01 $ (0.87)
================== ================= ==================
Diluted income (loss) per common share:
Continuing operations $ (0.53) $ 0.01 $ (0.61)
Discontinued operations - - (0.26)
------------------ ----------------- -----------------
Net income (loss) $ (0.53) $ 0.01 $ (0.87)
================== ================= =================
Conversion of the stock options, warrants and convertible subordinated debt
was not assumed for the years ended December 31, 2005 and 2003 because the
impact was anti-dilutive. The difference between the basic and diluted number of
weighted average shares outstanding for the year ended December 31, 2004
represents dilutive stock options and warrants to purchase shares of common
stock computed under the treasury stock method, using the average market price
during the period. The net loss for the year ended December 31, 2003 was
decreased by preferred stock dividends and related charges of $2,140,000 in
calculating the per share amounts. The preferred stock was converted into common
stock on October 23, 2003.
Concentration of credit risk
The Company is subject to concentration of credit risk with respect to
contract receivables. Credit risk on contract receivables is mitigated by the
nature of the Company's worldwide customer base and its credit policies. The
Company's customers are not concentrated in any specific geographic region, but
are concentrated in the energy industry. For the years ended December 31, 2005,
2004 and 2003, one customer accounted for approximately 25%, 24%, and 29%,
respectively, of the Company's revenue. As of December 31, 2005, the contracts
receivable balance related to this significant customer was approximately $1.0
million, or 15% of contract receivables, of which $501,000 was unbilled at
year-end.
Fair values of financial instruments
The carrying amounts of current assets, current liabilities, and long-term
debt reported in the Consolidated Balance Sheets approximate fair value.
Derivative Instruments
The Company utilizes foreign currency forward financial instruments to
manage market risks associated with the fluctuations in foreign currency
exchange rates. It is the Company's policy to use derivative financial
instruments to protect against market risk arising in the normal course of
business. The criteria the Company uses for designating an instrument as a hedge
include the instrument's effectiveness in risk reduction and one-to-one matching
of derivative instruments to underlying transactions. The Company monitors its
foreign currency exposures to maximize the overall effectiveness of its foreign
currency hedge positions. Principal currencies hedged include the Euro and the
Japanese Yen. The Company's objectives for holding derivatives are to minimize
the risks using the most effective methods to reduce the impact of these
exposures. The Company minimizes credit exposure by limiting counterparties to
nationally recognized financial institutions.
All derivatives, whether designated as hedging relationships or not, are
recorded on the balance sheet at fair value. If the derivative is designated as
a fair value hedge, the changes in the fair value of the derivative and of the
hedged item attributable to the hedged risk are recognized in earnings. If the
derivative is designated as a cash flow hedge, the change in the fair value of
the derivative and of the hedged item are recognized as an element of other
comprehensive income.
As of December 31, 2005 and 2004, the Company had contracts for the sale of
approximately 247 million and 435 million Japanese Yen, respectively, at fixed
rates. The contracts expire on various dates through May 2007. The Company has
not designated the contracts as hedges and, accordingly, has recorded the
estimated fair value of the contracts of $31,000 and $203,000 as of December 31,
2005 and 2004, respectively, as an other asset in the consolidated balance sheet
and other income (expense) in the consolidated statement of operations.
Reclassifications
Certain reclassifications have been made to prior year amounts to conform
with the current year presentation.
New Accounting Standards
In December 2004, the FASB issued SFAS No. 123R which revises SFAS No. 123
and supersedes APB No. 25. Currently, the Company does not record compensation
expense for certain stock-based compensation. Under SFAS No. 123R, the Company
will measure the cost of employee services received in exchange for stock, based
on the grant-date fair value with limited exceptions) of the stock award. Such
cost will be recognized over the period during which the employee is required to
provide service in exchange for the stock award (usually the vesting period).
The fair value of the stock award will be estimated using an option-pricing
model, with excess tax benefits, as defined in SFAS No. 123R, being recognized
as an adjustment to additional paid-in capital. The Company adopted SFAS No.
123R on January 1, 2006 using the Modified Prospective Application method
without restatement of prior periods. Under this method, the Company recognizes
compensation cost for the unvested fair value of its outstanding awards as of
January 1, 2006. Compensation cost for these awards will be based on the fair
value of the awards as disclosed on a pro forma basis under SFAS No. 123. The
Company will account for awards that are granted, modified, or settled after the
adoption date in accordance with SFAS No. 123R.
At December 31, 2005, all of the Company's outstanding options are fully
vested and thus there will be no compensation expense in 2006 related to the
adoption of SFAS No. 123R. The Company has not yet developed an estimate of
compensation expense related to future grants of stock options, which would
result in additional expense under SFAS No. 123R.
3. Discontinued Operations
In September 2003, the Company completed the sale of substantially all of
the assets of Process to Novatech pursuant to an Asset Purchase Agreement,
effective as of September 25, 2003. The Company received $5.5 million in cash,
subject to certain adjustments. The Company recognized a loss on this
transaction of $262,000. In conjunction with the transaction, Novatech purchased
certain assets with a book value of $11.7 million and assumed certain operating
liabilities totaling approximately $6.8 million. The Company incurred
approximately $865,000 of closing costs associated with the transaction. Results
of operations have been classified as discontinued operations.
The contract revenue and income (loss) for the discontinued Process
business was:
(in thousands) Years ended December, 31
---------------------------
2004 2003
------------- ------------
Contract revenue $ - $ 13,693
Income (loss) from discontinued operations 36 (1,671)
Loss from discontinued operations in 2003 includes losses of $115,000 from
the write down of the Company's investment in Avantium International BV. The
$36,000 of income from discontinued operations in 2004 relates to the favorable
resolution of certain contingencies which the Company had provided for at the
date of sale net of income taxes.
4. Contract receivables
Contract receivables represent balances due from a broad base of both
domestic and international customers. All contract receivables are considered to
be collectible within twelve months. Recoverable costs and accrued profit not
billed represent costs incurred and associated profit accrued on contracts that
will become billable upon future milestones or completion of contracts. The
components of contract receivables are as follows:
(in thousands) December 31,
2005 2004
----------- -------------
Billed receivables $3,445 $ 4,491
Recoverable costs and accrued profit not billed 3,696 4,256
Allowance for doubtful accounts (245) (24)
----------- -------------
Total contract receivables $6,896 $ 8,723
=========== =============
5. Prepaid expenses and other current assets
Prepaid expenses and other current assets consist of the following:
(in thousands) December 31,
2005 2004
------------ ------------
Prepaid expenses $ 228 $ 610
Employee advances 40 17
Other current assets 108 192
------------ ------------
Total $ 376 $ 819
============ ============
6. Equipment and leasehold improvements
Equipment and leasehold improvements consist of the following:
(in thousands) December 31,
--------------------------
2005 2004
----------- ------------
Computer equipment $2,039 $ 3,095
Leasehold improvements - 703
Furniture and fixtures 388 942
----------- ------------
2,427 4,740
Accumulated depreciation and amortization (2,098) (4,144)
----------- ------------
Equipment and leasehold improvements, net $ 329 $ 596
=========== ============
Depreciation and amortization expense was approximately $431,000, $280,000,
and $392,000 for the years ended December 31, 2005, 2004, and 2003,
respectively. Due to the relocation of the Company's Maryland operations from
Columbia, Maryland to Baltimore, Maryland in October 2005, the Company
accelerated the depreciation of certain leasehold improvements.
7. Software development costs
Software development costs, net, consist of the following:
(in thousands) December 31,
----------------------------
2005 2004
------------- -------------
Capitalized software development costs $1,896 $1,569
Accumulated amortization (956) (660)
------------- -------------
Software development costs, net $940 $909
============= =============
Software development costs capitalized were approximately $483,000,
$361,000, and $542,000 for the years ended December 31, 2005, 2004 and 2003,
respectively. Amortization of software development costs capitalized was
approximately $452,000, $398,000, and $339,000 for the years ended December 31,
2005, 2004 and 2003, respectively, and were included in cost of revenue.
8. Long-term Debt
The Company's long-term debt consists of the following:
(in thousands) December 31,
2005 2004
------------- ------------
Line of credit with bank $ 1,182 $ -
Senior convertible secured subordinated note payable 2,000 -
Notes payable, other - 9
------------- ------------
Total notes payable and financing arrangements 3,182 9
Less warrant related discount, net of accretion (318) -
Less convertible option discount, net of accretion (813) -
------------- ------------
2,051 9
Less current portion (1,182) (9)
------------- ------------
Long-term debt, less current portion $ 869 $ -
============= ============
Line of Credit
As of December 31, 2005, the Company has a line of credit with a bank
through General Physics Corporation, a wholly owned subsidiary of GP Strategies.
Under the terms of the agreement, $1.5 million of General Physics' available
credit facility has been carved out for use by GSE. The line is collateralized
by substantially all of the Company's assets and provides for borrowings up to
80% of eligible accounts receivable and 80% of eligible unbilled receivables. GP
Strategies guarantees GSE's borrowings under the credit facility, which
continued in place after the spin-off from GP Strategies. The interest rate on
this line of credit is based upon the Daily LIBOR Market Index Rate plus 3%
(7.38% as of December 31, 2005), with interest only payments due monthly. At
December 31, 2005, the Company's available borrowing base was $1.5 million, of
which $1,192,000 had been utilized, including $10,000 for a letter of credit.
The current credit facility was scheduled to expire on August 13, 2006; but on
March 7, 2006, the Company entered into a new loan and security agreement with
another financial institution. See Note 19, Subsequent events for a discussion
of the new credit facility.
Senior Convertible Secured Subordinated Note Payable
On May 26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP
a Senior Subordinated Secured Convertible Note in the aggregate principal amount
of $2,000,000, which matures March 31, 2009 (the "Dolphin Note"), and a
seven-year warrant to purchase 380,952 shares of GSE common stock at an exercise
price of $2.22 per share (the "GSE Warrant"). The Dolphin Note is convertible
into 1,038,961 shares of GSE common stock at a conversion price of $1.925 per
share and accrues interest at 8% payable quarterly. Both the Convertible Note
and the Warrant are subject to anti-dilution provisions. The aggregate purchase
price for the Dolphin Note and GSE Warrant was $2,000,000. At the date of
issuance, the fair value of the GSE Warrant and Conversion Option, which was
established using the Black-Scholes Model, was $375,000 and $959,000,
respectively, both of which were recorded as noncurrent liabilities, with the
offset recorded as original issue discount (OID). OID is accreted over the term
of the Dolphin Note and charged to interest expense, and the unamortized balance
is netted against long-term debt in the accompanying consolidated balance
sheets. The GSE Warrant and Conversion Option liabilities are marked to market
through earnings on a quarterly basis in accordance with EITF No. 00-19,
Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in a Company's Common Stock. For the year ended December 31, 2005, the
Company recognized a gain of $636,000 from the change in the fair value of these
liabilities. The gain is recorded in other income (expense), net in 2005. The
fair value of these liabilities was $698,000 as of December 31, 2005 and is
included in other liabilities in the consolidated balance sheet. On February 28,
2006, the Company completed a preferred stock offering and used a portion of the
proceeds to payoff the Dolphin Note. See Note 19, Subsequent events for a
discussion of the preferred stock transaction.
Note Payable, Other
The Company had an unsecured promissory note payable to a former employee.
The final payment on the note was made in April 2005.
Debt Maturities
Aggregate maturities of debt outstanding at December 31, 2005 are as
follows:
(in thousands)
2006 $ 1,182
2007 $ -
2008 $ -
2009 $ 2,000
------------
Total $ 3,182
============
On February 28, 2006, the Company completed a preferred stock offering and
used a portion of the proceeds to pay off all of its outstanding long-term debt.
See Note 19, Subsequent events for a discussion of the preferred stock
transaction.
9. Income taxes
The consolidated income (loss) before income taxes, by domestic and foreign
sources, is as follows:
(in thousands) Years ended December 31,
---------------------------------------------
2005 2004 2003
------------- ------------- ------------
Domestic $ (3,733) $ 42 $ (3,609)
Foreign (913) 166 196
------------- ------------- ------------
Total $ (4,646) $ 208 $ (3,413)
============= ============= ============
---------------------------------------------
The provision for income taxes is as follows:
(in thousands) Years ended December 31,
-------------------------------------------
2005 2004 2003
------------- ------------- -------------
Current:
Federal $ - $ 1 $ -
State (4) 18 53
Foreign 103 121 66
------------- ------------- -------------
Subtotal 99 140 119
------------- ------------- -------------
Deferred:
Federal and state - - -
Foreign 50 (50) -
------------- ------------- -------------
Subtotal 50 (50) -
------------- ------------- -------------
Total $ 149 $ 90 $ 119
============= ============= =============
The allocation of the provision for income taxes to continuing and discontinued operations is as
follows:
Continuing operations $ 149 $ 60 $ 93
Discontinued operations - 30 26
------------- ------------- -------------
$ 149 $ 90 $ 119
============= ============= =============
The difference between the provision for income taxes included in income
(loss) from continuing operations computed at the applicable U.S. statutory rate
and the reported provision for income taxes is as follows:
Effective tax rate percentage (%)
Years ended December 31,
--------------------------------------------
2005 2004 2003
------------ ------------ ------------
Statutory U.S. tax rate (34.0)% 34.0 % (34.0)%
State income tax, net of federal tax benefit - 5.7 1.0
Effect of foreign operations 3.1 (6.0) (0.1)
Change in valuation allowance 34.0 1.0 36.1
Other, principally permanent differences 0.1 7.6 2.3
------------ ------------ ------------
Effective tax rate 3.2 % 42.3 % 5.3 %
============ ============ ============
Deferred income taxes arise from temporary differences between the tax
bases of assets and liabilities and their reported amounts in the financial
statements. A summary of the tax effect of the significant components of the
deferred income tax assets (liabilities) is as follows:
(in thousands) December 31,
----------------------------------------
2005 2004 2003
------------ ------------ ------------
Net operating loss carryforwards $ 8,035 $ 6,246 $ 6,133
Investments 1,658 1,658 1,570
Foreign tax credits 378 378 378
Accrued expenses 138 260 288
Expenses not currently deductible for tax purposes 449 285 268
Alternative minimum tax credit caryforwards 162 162 162
Property and equipment (7) (29) 34
Software development costs (345) (322) (347)
Other (107) 145 95
------------ ------------ ------------
Net deferred tax assets 10,361 8,783 8,581
Less valuation allowance (10,361) (8,733) (8,581)
------------ ------------ ------------
Net deferred tax assets, net of valuation allowance $ - $ 50 $ -
============ ============ ============
In assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some or all of the deferred tax assets
will not be realized. The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during the periods in
which those temporary differences become deductible. Management considers the
scheduled reversal of deferred tax liabilities and projected future income in
making this assessment. Management could not substantiate recovery of the net
deferred tax assets with currently available objective evidence. Accordingly,
the Company has established a $10,361,000 valuation allowance for the deferred
tax assets as of December 31, 2005. The valuation allowance for deferred tax
assets increased by $1,628,000 in 2005, by $152,000 in 2004, and by $806,000 in
2003.
At December 31, 2005, the Company had available $20,426,000 and $1,785,000
of domestic and foreign net operating loss carryforwards, respectively, which
expire between 2012 and 2025 The amount of loss carryforward which can be used
by the Company may be limited.
10. Capital stock
The Company's Board of Directors has authorized 20,000,000 total shares of
capital stock, of which 18,000,000 are designated as common stock and 2,000,000
are designated as preferred stock. The Board of Directors has the authority to
establish one or more classes of preferred stock and to determine, within any
class of preferred stock, the preferences, rights and other terms of such class.
In June 2003, the Company issued 100,000 warrants at an exercise price of
$1.33 per share, the closing price on July 8, 2003 as consideration to ManTech
for issuing letters of credit on the Company's behalf. The Company pays ManTech
a fee equal to 7% per annum, paid quarterly, on the total amount of the value of
the outstanding letters of credit which expire August 2006. The Company
amortized the estimated fair value of these warrants ($86,000) over the life of
the project as additional contract costs. The warrants are outstanding as of
December 31, 2005.
On October 23, 2003, ManTech converted its preferred stock to 2,511,915
shares of GSE common stock. See the discussion of this transaction in Note 11,
Series A Convertible Preferred Stock.
On October 23, 2003, GP Strategies purchased a $650,000 unsecured
subordinated promissory note from ManTech. The terms of the subordinated note
were amended by the Company to allow the conversion of the subordinated debt to
GSE common stock at a rate of $1.5526. GP Strategies converted the note on
October 23, 2003 and received 418,653 shares of GSE common stock.
On May 26, 2005, GSE issued and sold the "Dolphin Note" and a seven-year
warrant to purchase 380,952 shares of GSE common stock at an exercise price of
$2.22 per share (the "GSE Warrant"). The Dolphin Note is convertible into
1,038,961 shares of GSE common stock at a conversion price of $1.925 per share
and accrues interest at 8% payable quarterly. Both the convertible note and the
warrant are subject to anti-dilution provisions. The warrants are outstanding as
of December 31, 2005. See Note 19, Subsequent events.
As of December 31, 2005, the Company has reserved 3,555,091 shares of
common stock for issuance upon exercise of stock options and warrants and the
conversion of the outstanding Senior Subordinated Secured Convertible Note.
11. Series A Convertible Preferred Stock
On December 5, 2001, ManTech converted $3.9 million of subordinated debt
into Series A convertible preferred stock at a conversion rate of $100 per
share. The Series A convertible preferred stock had no voting rights and
accumulated dividends at the rate of 6% per annum payable quarterly. As of
December 31, 2005, the Company had accrued dividends payable to ManTech of
$366,000. The unpaid dividends accrue interest at 6% per annum. At December 31,
2005 the Company had an accrual for interest payable of $60,000.
ManTech, at its discretion, had the right to convert each share of Series A
convertible preferred stock into GSE common stock at a purchase price of $2.645
per share at any time after a one-year holding period from the date of issuance.
On September 29, 2003, the Company amended the Preferred Stock issuance
agreement to revise the conversion rate to $1.5526 per share. The change in
conversion rate increased the number of common shares available upon conversion
from 1,474,480 to 2,511,915. On October 23, 2003, ManTech converted all of its
preferred stock to common stock in conjunction with the sale of its ownership in
GSE to GP Strategies. The additional common shares that ManTech received in the
conversion due to the change in conversion rate have been recorded as a
beneficial conversion premium, valued at $1,950,000 based upon the closing
market price per share ($1.88) as of October 23, 2003, and a reduction in income
attributable to common stockholders.
On February 28, 2006, the Company completed a preferred stock offering. See
Note 19, Subsequent events for a discussion of the preferred stock transaction.
12. Stock options
Long term incentive plan
During 1995, the Company established the 1995 Long-Term Incentive Stock
Option Plan (the "Plan"), which includes all officers, key employees and
non-employee members of the Company's Board of Directors. All options to
purchase shares of the Company's common stock under the Plan expire seven years
from the date of grant and generally become exercisable in three installments
with 40% vesting on the first anniversary of the grant date and 30% vesting on
each of the second and third anniversaries of the grant date, subject to
acceleration under certain circumstances. As of December 31, 2005, the Company
had 368,442 shares of common stock reserved for future grants under the Plan.
Stock option and warrant activity, including options and warrants issued in
addition to the Company's Long-Term Incentive Stock Option Plan, is as follows:
Weighted
Average
Shares Exercise Price
--------------- -------------------
Options and warrants outstanding, as of January 1, 2003 2,139,476 $ 3.28
Options and warrants exercised 100,000 1.33
Options and warrants canceled (335,500) 2.36
Options and warrants granted - -
---------------
Options and warrants outstanding, as of December 31, 2003 1,903,976 $ 3.95
Options and warrants exercised - -
Options and warrants canceled (37,200) 3.79
Options and warrants granted - -
---------------
Options and warrants outstanding, as of December 31, 2004 1,866,776 $ 3.96
Options and warrants exercised (50,000) 2.00
Options and warrants canceled (281,598) 6.91
Options and warrants granted 980,952 1.99
---------------
Options and warrants outstanding, as of December 31, 2005 2,516,130 $ 2.90
===============
The following table summarizes information relating to currently
outstanding and exercisable options and warrants at December 31, 2005:
Options and Warrants Outstanding Options and Warrants Exercisable
-------------------------------------------------- --------------------------------------
Weighted
Average
Options Remaining Weighted Options Weighted
Range of and Warrants Contract Average and Warrants Average
Exercise Prices Outstanding Life in Years Exercise Price Exercisable Exercise Price
- ------------------------ --------------- --------------- ---------------- ---------------- ----------------
$0.00 - $1.48 175,000 2.4 $ 1.19 175,000 $ 1.19
$1.49 - $2.95 1,335,355 5.0 2.03 1,335,355 2.03
$2.96 - $4.43 739,485 0.8 3.70 739,485 3.70
$4.44 - $5.90 200,000 1.1 4.75 200,000 4.75
$5.91 - $7.38 10,000 1.3 6.38 10,000 6.38
$7.39 - $8.85 20,000 1.2 7.50 20,000 7.50
$8.86 - $11.80 17,700 1.1 11.25 17,700 11.25
$11.81 - $14.75 18,590 0.4 14.75 18,590 14.75
--------------- ----------------
Total 2,516,130 3.2 $ 2.90 2,516,130 $ 2.90
=============== ================
13. Commitments and contingencies
Leases
The Company is obligated under certain noncancelable operating leases for
office facilities and equipment. Future minimum lease payments under
noncancelable operating leases as of December 31, 2005 are as follows:
(in thousands) Gross future Assignment Sublease Net future
minimum lease of rental minimum lease
payments lease income payments
------------------ -------------- ------------- ------------------
2006 $ 1,763 $ (594) $ (4) $ 1,165
2007 1,515 (666) - 849
2008 839 (457) - 382
Thereafter - - - -
------------------ -------------- ------------- ------------------
Total $ 4,117 $ (1,717) $ (4) $ 2,396
================== ============== ============= ==================
Total rent expense under operating leases for the years ended December 31,
2005, 2004, and 2003 was approximately $1.3 million, $1.2 million, and $998,000,
respectively.
The Company subleased 3520 sq. ft. of space in the Columbia, Maryland
facility which terminated in October 2005 and February 2006. For the years ended
December 31, 2005, 2004 and 2003, such sublease rentals amounted to $71,000,
$80,000, and $71,000, respectively.
In October 2005, the Company signed an "Assignment of Lease and Amendment
to Lease" that assigns and transfers to another tenant (the "assignee") the
Company's rights, title and interest in its Columbia, Maryland facility lease.
The assignee's obligation to pay rent under the Lease began on February 1, 2006.
The Company remains fully liable for the payment of all rent and for the
performance of all obligations under the lease through the scheduled expiration
of the lease, May 31, 2008, should the assignee default on their obligations.
The Company relocated its Maryland operations from its Columbia facility to its
Baltimore facility in October 2005.
Letters of credit and performance bonds
As of December 31, 2005, the Company was contingently liable for
approximately $56,000 under one letter of credit used as a payment bond on a
contract, which was secured by a cash deposit classified as restricted cash and
included in other assets in the consolidated balance sheet. The Company also was
contingently liable for $10,000 under a letter of credit used as a bid bond on
an outstanding proposal, which was secured by the Company's credit facility. In
addition, the Company was contingently liable at December 31, 2005 for
approximately $30,000 under a performance bond on one contract, which was
secured by a bank guarantee of the Company's foreign subsidiary.
Contingencies
Various actions and proceedings are presently pending to which the Company
is a party. In the opinion of management, the aggregate liabilities, if any,
arising from such actions are not expected to have a material adverse effect on
the financial position, results of operations or cash flows of the Company.
14. Related party transactions
Prior to the spin-off discussed in Note 1, Business and basis of
presentation, GP Strategies owned 57% of the Company.
On January 1, 2004, the Company entered into a Management Services
Agreement with GP Strategies Corporation in which GP Strategies agreed to
provide corporate support services to GSE, including accounting, finance, human
resources, legal, network support and tax. GSE was charged $685,000 for GP
Strategies' services in both 2005 and 2004. The agreement has been extended
through December 31, 2006 without an increase in the fee. In addition, in 2004
GSE was charged $289,000 by GP Strategies for compensation and benefits of the
Company's CEO who was an employee of GP Strategies until December 16, 2004.
In 2003, GSE was charged $100,000 for management services and insurance
coverage for November and December 2003.
15. Employee benefits
The Company has a qualified defined contribution plan that covers
substantially all U.S. employees under Section 401(k) of the Internal Revenue
Code. Under this plan, the Company's stipulated basic contribution matches a
portion of the participants' contributions based upon a defined schedule. The
Company's contributions to the plan were approximately $93,000, $110,000, and
$239,000 for the years ended December 31, 2005, 2004, and 2003, respectively.
16. Segment information
The Company has one reportable business segment that provides simulation
solutions and services to the nuclear and fossil electric utility industry, the
chemical and petrochemical industries and to the U.S. Military Complex.
Contracts typically range from 10 months to three years.
For the years ended December 31, 2005, 2004, and 2003, one customer
(Battelle's Pacific Northwest National Laboratory) accounted for approximately
25%, 24%, and 29%, respectively, of the Company's consolidated revenue. The
Pacific Northwest National Laboratory is the purchasing agent for the Department
of Energy and the projects the Company performs in Eastern and Central Europe.
For the years ended December 31, 2005, 2004, and 2003, 83%, 85%, and 89% of
the Company's consolidated revenue was from customers in the nuclear power
industry, respectively. The Company designs, develops and delivers business and
technology solutions to the energy industry worldwide. Revenue, operating income
(loss) and total assets for the Company's United States, European, and Asian
subsidiaries as of and for the years ended December 31, 2005, 2004, and 2003 are
as follows:
(in thousands) Year ended December 31, 2005
-----------------------------------------------------------------------------
United States Europe Asia Eliminations Consolidated
--------------- -------------- ---------- ------------- ---------------
Contract revenue $ 19,045 $ 2,899 $ 6 $ - $ 21,950
Transfers between geographic locations 34 57 56 (147) -
--------------- -------------- ---------- ------------- ---------------
Total contract revenue $ 19,079 $ 2,956 $ 62 $ (147) $ 21,950
=============== ============== ========== ============= ===============
Operating income (loss) $ (3,995) $ (647) $ (85) - $ (4,727)
=============== ============== ========== ============= ===============
Identifiable assets, at December 31 $ 37,803 $ 2,282 $ 31 $ (28,134) $ 11,982
=============== ============== ========== ============= ===============
(in thousands) Year ended December 31, 2004
-----------------------------------------------------------------------------
United States Europe Asia Eliminations Consolidated
--------------- -------------- ---------- ------------- ---------------
Contract revenue $ 24,774 $ 4,724 $ 16 $ - $ 29,514
Transfers between geographic locations 132 10 70 (212) -
--------------- -------------- ---------- ------------- ---------------
Total contract revenue $ 24,906 $ 4,734 $ 86 $ (212) $ 29,514
=============== ============== ========== ============= ===============
Operating income (loss) $ 89 $ (7) $ (80) $ - $ 2
=============== ============== ========== ============= ===============
Identifiable assets, at December 31 $ 38,711 $ 3,618 $ 33 $ (28,134) $ 14,228
=============== ============== ========== ============= ===============
(in thousands) Year ended December 31, 2003
-----------------------------------------------------------------------------
United States Europe Asia Eliminations Consolidated
--------------- -------------- ---------- ------------- ---------------
Contract revenue $ 21,214 $ 3,661 $ 144 $ - $ 25,019
Transfers between geographic locations 162 - - (162) -
--------------- -------------- ---------- ------------- ---------------
Total contract revenue $ 21,376 $ 3,661 $ 144 $ (162) $ 25,019
=============== ============== ========== ============= ===============
Operating income (loss) $ (1,313) $ 346 $ (24) $ - $ (991)
=============== ============== ========== ============= ===============
Approximately 63%, 65%, and 70% of the Company's 2005, 2004 and 2003
revenue, respectively, was derived from international sales of its products and
services from all of its subsidiaries.
17. Supplemental disclosure of cash flow information
(in thousands) Years ended December 31,
2005 2004 2003
------------ ------------ -------------
Issuance of options/warrants to
non-employees (see Note 10) $ - $ - $ 86
============ ============ =============
Conversion of related party note payable to
common stock $ - $ - $ 787
============ ============ =============
Conversion of preferred stock to
common stock $ - $ - $ 3,900
============ ============ =============
Cash paid:
Interest $ 156 $ 96 $ 668
============ ============ =============
Income taxes $ 157 $ 94 $ 138
============ ============ =============
18. Quarterly financial data (unaudited)
The Company's quarterly financial information has not been audited but, in
management's opinion, includes all adjustments necessary for a fair
presentation.
(in thousands, except per share data) Year ended December 31, 2005 Quarterly Data
-----------------------------------------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
--------------- ------------------ ---------------- ---------------
Contract revenue $ 6,293 $ 6,717 $ 4,607 $ 4,333
Operating income (loss) (1,023) (374) (1,430) (1,900)
Loss from continuing operations and net loss $ (1,042) $ (556) $ (1,047) $ (2,150)
=============== ================== ================ ===============
Basic loss per common share:
Continuing operations and net loss $ (0.12) $ (0.06) $ (0.12) $ (0.24)
=============== ================== ================ ===============
Diluted loss per common share:
Continuing operations and net loss $ (0.12) $ (0.06) $ (0.12) $ (0.24)
=============== ================== ================ ===============
(in thousands, except per share data) Year ended December 31, 2004 Quarterly Data
-----------------------------------------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
--------------- ------------------ ---------------- ---------------
Contract revenue $ 7,561 $ 7,597 $ 7,340 $ 7,016
Operating loss 224 333 (255) (300)
Loss from continuing operations 64 276 (197) (61)
Loss from discontinued operations - - 60 (24)
--------------- ------------------ ---------------- ---------------
Net loss $ 64 $ 276 $ (137) $ (85)
=============== ================== ================ ===============
Basic loss per common share:
Continuing operations and net loss $ 0.01 $ 0.03 $ (0.02) $ (0.01)
=============== ================== ================ ===============
Diluted loss per common share:
Continuing operations and net loss $ 0.01 $ 0.03 $ (0.02) $ (0.01)
=============== ================== ================ ===============
19. Subsequent events
On February 28, 2006, the Company and Dolphin entered into a Cancellation
and Warrant Exchange Agreement (the "Cancellation Agreement" ) under which
Dolphin agreed to cancel its Senior Subordinated Secured Convertible Promissory
Note and cancel its outstanding warrant to purchase 380,952 shares of GSE common
stock at an exercise price of $2.22 per share. In exchange for Dolphin's
agreement to enter into the Cancellation Agreement and for the participation of
Dolphin Offshore Partners, LP in the Preferred Stock transaction discussed
below, the Company paid off the Dolphin Note and agreed to issue a new warrant
to purchase 900,000 shares of GSE common stock at an exercise price of $.67 per
share. Dolphin must exercise the new warrant promptly after the Company
certifies to Dolphin on or after May 30, 2006 (the "Mandatory Exercise Date")
that, among other things, the current stock price shall not be less than $1.25
on the Mandatory Exercise Date and that the average of the current stock prices
for each trading day of the 30 calendar day period up to and including the
Mandatory Exercise Date is not less than $1.25.
On February 28, 2006, the Company raised $4.25 million through the sale of
42,500 shares of Series A Cumulative Convertible Preferred Stock and Warrants by
means of a private placement to "accredited investors", as that term is used in
rules and regulations of the Securities and Exchange Commission. The Convertible
Preferred Stock is convertible at any time into a total of 2,401,130 shares of
GSE common stock at a conversion price of $1.77 per share. The conversion price
was equal to 110% of the closing price of the Company's Common Stock on February
28, 2006, the date the sale of the Convertible Preferred Stock was completed.
Each investor received a five-year warrant to purchase GSE common stock equal to
20% of the shares they would received from the conversion of the Convertible
Preferred Stock, at an exercise price of $1.77. In total, the Company issued
warrants to purchase a total of 480,226 shares of GSE common stock. The
Convertible Preferred Stock holders are entitled to an 8% cumulative dividend,
payable on a semiannual basis every June 30 and December 30. If the Company does
not make two consecutive dividend payments on the dates such payments are due,
there will be an additional 30% warrant coverage of five-year warrants at a
conversion price of $1.77 per share. At any time after March 1, 2007, the
Company has the right to convert the Preferred Stock into shares of GSE common
stock when the average of the current stock price during the twenty trading days
immediately prior to the date of such conversion exceeds 200% of the Series A
Conversion Price. The holders of the Convertible Preferred Stock are entitled to
vote on all matters submitted to the stockholders for a vote, together with the
holders of the voting common stock, all voting together as a single class. The
holders of the Convertible Preferred Stock are entitled to the number of votes
equal to the number of GSE common stock that they would receive upon conversion
of their Convertible Preferred Stock.
The Company paid the placement agent 6% of the gross proceeds received by
the Company from the offering ($255,000) plus five-year warrants to purchase
150,000 shares of the Company's common stock at an exercise price of $1.77 per
share.
The proceeds were used to payoff the Dolphin Note and the Company's line of
credit balance and for other working capital purposes.
On March 7, 2006, the Company entered into a new loan and security
agreement with Laurus Master Fund, Ltd. The new agreement established a $5.0
million line of credit for the Company. The line is collateralized by
substantially all of the Company's assets and provides for borrowings up to 90%
of eligible accounts receivable, and 40% of eligible unbilled receivables (up to
a maximum of $1.0 million). The interest rate on this line of credit is based on
the prime rate plus 200-basis points, with interest only payments due monthly.
The Company issued to Laurus Master Fund, Ltd. a warrant to purchase up to
367,647 shares of GSE common stock at an exercise price of $.01 per share.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
ITEM 9A. CONTROLS AND PROCEDURES.
The Company maintains disclosure controls and procedures that are designed
to ensure that information required to be disclosed by it in its reports filed
or submitted pursuant to the Securities Exchange Act of 1934, as amended
(Exchange Act), is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission's rules and forms
and that information required to be disclosed by the Company in its Exchange Act
reports is accumulated and communicated to management, including the Company's
Chief Executive Officer and Chief Financial Officer, to allow timely decisions
regarding required disclosure.
During the fourth quarter 2005, there have been no changes in internal
control over financial reporting that have materially affected, or are
reasonably likely to materially affect, the Company's internal control over
financial reporting.
Based on their evaluation as of the end of the period covered by this Form
10-K, the Company's principal executive officer and principal financial officer
have concluded that the Company's disclosure controls and procedures (as defined
in Rules 13a-15(e) under the Securities Exchange Act of 1934 (the "Exchange
Act") are effective to ensure that information required to be disclosed by the
Company in reports that if files or submits under the Exchange Act is recorded,
processed, and summarized and reported within the time periods specified in
Securities and Exchange Commission rules and forms.
Limitation of Effectiveness of Controls
It should be noted that any system of controls, however well designed and
operated, can provide only reasonable, and not absolute, assurance that the
objectives of the system will be met. The design of any control system is based,
in part, upon the benefits of the control system relative to its costs. Because
of the inherent limitations in all control systems, no evaluation of controls
can provide absolute assurance that all control issues and instances of fraud,
if any, within the Company have been detected. These inherent limitations
include the realities that judgments in decision making can be faulty, and that
controls can be circumvented by the individual acts of some persons, by
collusion of two or more people or by management override of control. In
addition, over time, controls may become inadequate because of changes in
conditions, or the degree of compliance with the policies or procedures may
deteriorate. In addition, the design of any control system is based in part upon
certain assumpt ions about the likelihood of future events. Because of inherent
limitation in a cost-effective control system, misstatements due to error or
fraud may occur and not be detected. The Company's controls and procedures are
designed to provide a reasonable level of assurance of achieving their
objectives.
ITEM 9B. OTHER INFORMATION
None.
PART III
The information required in response to Items 10, 11, 12 13, and 14 is
hereby incorporated by reference to the information under the captions "Election
of Directors", "Principal Executive Officers of the Company Who Are Not Also
Directors", "Executive Compensation", "Voting Securities and Principal
Stockholders", "Security Ownership of Management", "Certain Related
Transactions" and "Principal Accountant Fees and Services" in the Proxy
Statement for the Company's 2006 Annual Meeting of Shareholders.
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) (1) List of Financial Statements
The following financial statements are included in Item 8:
GSE Systems, Inc. and Subsidiaries
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2005 and 2004
Consolidated Statements of Operations for the years ended December 31,
2005, 2004, and 2003
Consolidated Statements of Comprehensive Income (Loss) for the years
ended December 31, 2005, 2004, and 2003
Consolidated Statements of Changes in Stockholders' Equity for the years
ended December 31, 2005, 2004, and 2003
Consolidated Statements of Cash Flows for the years ended December 31,
2005, 2004, and 2003
Notes to Consolidated Financial Statements
(a) (2) List of Schedules
All other schedules to the consolidated financial statements are omitted as
the required information is either inapplicable or presented in the consolidated
financial statements or related notes.
(a) (3) List of Exhibits
The Exhibits which are filed with this report or which are incorporated by
reference are set forth in the Exhibit Index hereto.
SIGNATURES
- ----------
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
GSE Systems, Inc.
By: / S / JOHN MORAN
-------------------------
John Moran
Chief Executive Officer
Pursuant to the requirements of the Securities Act, this report has been signed
by the following persons in the capacities and on the dates indicated.
Date: March 31, 2006 / S / JOHN MORAN
-------------------------
John Moran, Chief Executive Officer
(Principal Executive Officer)
Date: March 31, 2006 / S / JEFFERY G. HOUGH
-------------------------
Jeffery G. Hough, Senior Vice
President and Chief Financial
Officer
(Principal Financial and Accounting
Officer)
Date: March 31, 2006
(Jerome I. Feldman, Chairman of the Board) By: / S / JEFFERY G. HOUGH
(Michael D. Feldman, Director ) -------------------------
(Dr. Sheldon L. Glashow, Director ) Jeffery G. Hough
(Scott N. Greenberg, Director ) Attorney-in-Fact
(Dr. Roger Hagengruber, Director )
(Andrea Kantor, Director )
(Joseph W. Lewis, Director )
(George J. Pedersen, Director )
(Douglas Sharp, Director )
A Power of Attorney, dated March 17, 2006 authorizing Jeffery G. Hough to
sign this Annual Report on Form 10-K for the fiscal year ended December 31, 2005
on behalf of certain of the directors of the Registrant is filed as Exhibit 24
to this Annual Report.
Exhibit Description of Exhibit
- ----------------------------------------------------------------------------
3. Articles of Incorporation and Bylaws
3(i) 1. Third Amended and Restated Certificate of Incorporation of the
Company. Previously filed in connection with the GSE Systems,
Inc. Form 8-K as filed with the Securities and Exchange
Commission on October 24, 2001 and incorporated herein by
reference.
3(ii)1. Form of Amended and Restated Bylaws of the Company. Previously
filed in connection with Amendment No. 1 to the GSE Systems, Inc.
Form S-1 Registration Statement as filed with the Securities and
Exchange Commission on June 14, 1995 and incorporated herein by
reference.
4. Instruments Defining Rights of Security Holders, including Indenture.
4.1 Specimen Common Stock Certificate of the Company. Previously
filed in connection with Amendment No. 3 to the GSE Systems, Inc.
Form S-1 Registration Statement as filed with the Securities and
Exchange Commission on July 24, 1995 and incorporated herein by
reference.
4.2 Preferred Stock Issuance Agreement by and between GSE Systems,
Inc. and ManTech International Corporation (dated December 5,
2001). Previously filed in connection with the GSE Systems, Inc.
Form 8-K as filed with the Securities and Exchange Commission on
December 12, 2001 and incorporated herein by reference.
4.3 Cancellation and Warrant Exchange Agreement dated February 28,
2006 by and among GSE Systems, Inc. and Dolphin Direct Equity
Partners, LP. Previously filed in connection with the GSE
Systems, Inc. Form 8-K filed with the Securities and Exchange
Commission on March 6, 2006, and incorporated herein by
reference.
4.4 Registration Rights Agreement dated February 28, 2006 by and
among GSE Systems, Inc. and Dolphin Direct Equity Partners, LP.
Previously filed in connection with the GSE Systems, Inc. Form
8-K filed with the Securities and Exchange Commission on March 6,
2006, and incorporated herein by reference.
4.5 Senior Subordinated Secured Convertible Note and Warrant Purchase
Agreement dated as of May 26, 2005 by and among GSE Systems, Inc.
and Dolphin Direct Equity Partners, LP. Previously filed in
connection with the GSE Systems, Inc. Form 8-K filed with the
Securities and Exchange Commission on March 6, 2006, and
incorporated herein by reference.
4.6 Form of Senior Subordinated Secured Convertible Promisson Note
dated as of May 26, 2005 issued by and among GSE Systems, Inc.
and Dolphin Direct Equity Partners, LP. Previously filed in
connection with the GSE Systems, Inc. Form 8-K filed with the
Securities and Exchange Commission on March 6, 2006, and
incorporated herein by reference.
4.7 Form of Warrant to Purchase 900,000 shares of Common Stock of GSE
Systems, Inc. dated as of February 28, 2006. Previously filed in
connection with the GSE Systems, Inc. Form 8-K filed with the
Securities and Exchange Commission on March 6, 2006, and
incorporated herein by reference.
4.8 Form of Warrant to Purchase 380,952 shares of Common Stock of GSE
Systems, Inc. dated as of May 26, 2005. Previously filed in
connection with the GSE Systems, Inc. Form 8-K filed with the
Securities and Exchange Commission on March 6, 2006, and
incorporated herein by reference.
4.9 Form of Warrant to Purchase shares of Common Stock of GSE
Systems, Inc. dated as of February 28, 2006. Previously filed in
connection with the GSE Systems, Inc. Form 8-K filed with the
Securities and Exchange Commission on March 6, 2006, and
incorporated herein by reference.
4.10 Certificate of Designation, Preferences and Rights of Series A
Cumulative Preferred Stock dated as of February 28, 2006
providing for the issuance of a series of 42,500 shares of Series
A Cumulative Convertible Preferred Stock, par value $0.01 per
share. Previously filed in connection with the GSE Systems, Inc.
Form 8-K filed with the Securities and Exchange Commission on
March 6, 2006, and incorporated herein by reference.
4.11 Form of Warrant to Purchase 367,647 shares of the Company's
Common Stock dated as of March 7, 2006. Previously filed in
connection with the GSE Systems, Inc. Form 8-K filed with the
Securities and Exchange Commission on March 13, 2006, and
incorporated herein by reference.
4.12 Grant of Security Interest in Patents and Trademarks by and among
GSE Systems, GSE Power Systems, Inc. and Laurus Master Fund, Ltd.
dated March 7, 2006. Previously filed in connection with the GSE
Systems, Inc. Form 8-K filed with the Securities and Exchange
Commission on March 13, 2006, and incorporated herein by
reference.
4.13 Subsidiary Guaranty by and among GSE Company Services LLC, MSHI,
Inc., GSE Power Systems, Inc., GSE Erudite Software Inc., GSE
Government & Military Simulation Systems, Inc., and GSE Process
Solutions, Inc. and Laurus Master Fund, Ltd. dated as of March 7,
2006. Previously filed in connection with the GSE Systems, Inc.
Form 8-K filed with the Securities and Exchange Commission on
March 13, 2006, and incorporated herein by reference.
4.14 Control Agreement by and among GSE Systems, Inc., Laurus Master
Fund Ltd. and GSE Services Company LLC dated as of March 7, 2006.
Previously filed in connection with the GSE Systems, Inc. Form
8-K filed with the Securities and Exchange Commission on March
13, 2006, and incorporated herein by reference.
4.15 Security Agreement by and among GSE Systems, Inc., GSE Power
Systems, Inc. and Laurus Master Fund, Ltd. dated as of March 7,
2006. Previously filed in connection with the GSE Systems, Inc.
Form 8-K filed with the Securities and Exchange Commission on
March 13, 2006, and incorporated herein by reference.
4.16 Registration Rights Agreement by and among GSE Systems, Inc. and
Laurus Master Fund, Ltd. dated as of March 7, 2006. Previously
filed in connection with the GSE Systems, Inc. Form 8-K filed
with the Securities and Exchange Commission on March 13, 2006,
and incorporated herein by reference.
4.17 Stock Pledge Agreement by and among the Company, MSHI, Inc., GSE
Power Systems, Inc., GSE Process Solutions, Inc. and Laurus
Master Fund, Ltd. dated as of March 7, 2006. Previously filed in
connection with the GSE Systems, Inc. Form 8-K filed with the
Securities and Exchange Commission on March 13, 2006, and
incorporated herein by reference.
4.18 Secured Non-convertible Revolving Note dated as of March 7, 2006.
Previously filed in connection with the GSE Systems, Inc. Form
8-K filed with the Securities and Exchange Commission on March
13, 2006, and incorporated herein by reference.
10. Material Contracts
10.1 Agreement among ManTech International Corporation, National
Patent Development Corporation, GPS Technologies, Inc., General
Physics Corporation, Vattenfall Engineering AB and GSE Systems,
Inc. (dated as of April 13, 1994). Previously filed in connection
with the GSE Systems, Inc. Form S-1 Registration Statement as
filed with the Securities and Exchange Commission on April 24,
1995 and incorporated herein by reference.
10.2 GSE Systems, Inc. 1995 Long-Term Incentive Plan, amended as of
April 28, 2005. Previously filed in connection with the GSE
Systems, Inc. Form DEF14A as filed with the Securities and
Exchange Commission on May 31, 2005 and incorporated herein by
reference.*
10.3 Form of Option Agreement Under the GSE Systems, Inc. 1995
Long-Term Incentive Plan. Previously filed in connection with the
GSE Systems, Inc. Form 10-K as filed with the Securities and
Exchange Commission on March 22, 1996 and incorporated herein by
reference.*
10.4 Office Lease Agreement between Sterling Rutherford Plaza, L.L.C.
and GSE Systems, Inc. (dated as of February 10, 1998). Previously
filed in connection with the GSE Systems, Inc. Form 10-K as filed
with the Securities and Exchange Commission on March 21, 1998 and
incorporated herein by reference.
10.5 Office Lease Agreement between Red Branch Road, L.L.C. and GSE
Systems, Inc. (dated February 10, 1998). Previously filed in
connection with the GSE Systems, Inc. Form 10-K as filed with the
Securities and Exchange Commission on March 21, 1998 and
incorporated herein by reference.
10.6 Assignment of Lease and Amendment of Lease between GSEM, LLC and
GSE Systems, Inc. filed herewith.
10.7 Preferred Stock Issuance Agreement by and between GSE Systems,
Inc. and ManTech International Corporation (dated December 5,
2001). Previously filed in connection with the GSE Systems, Inc.
Form 8-K as filed with the Securities and Exchange Commission on
December 12, 2001 and incorporated herein by reference.
10.8 Asset Sale and Purchase Agreement between GSE Systems, Inc. and
Novatech LLC dated September 25, 2003. Previously filed in
connection with the GSE Systems, Inc. Form 8-K as filed with the
Securities and Exchange Commission on October 10, 2003 and
incorporated herein by reference.
10.9 Management Services Agreement between GSE Systems, Inc. and GP
Strategies Corporation dated January 1, 2004. Previously filed in
connection with the GSE Systems, Inc. Form 10-K filed with the
Securities and Exchange Commission on April 14, 2004 and
incorporated herein by reference.
10.10 First Amendment dated March 30, 2004 to the Financing and
Security Agreement among General Physics Corporation, Skillright,
Inc., GSE Systems, Inc., GSE Power Systems, Inc., and MSHI, Inc.
and Wachovia Bank, National Association. Previously filed in
connection with the GSE Systems, Inc. Form 10-K filed with the
Securities and Exchange Commission on April 14, 2004 and
incorporated herein by reference.
10.11 Third Amendment dated July 30, 2004 to the Financing and
Security Agreement among General Physics Corporation, Skillright,
Inc., GSE Systems, Inc., GSE Systems, Inc., GSE Power Systems,
Inc. and MSHI, Inc. and Wachovia Bank National Association.
Previously filed in connection with the GSE Systems, Form 10-Q
filed with the Securities and Exchange Commission on November 12,
2004 and incorporated herein by reference.
10.12 Forbearance letter dated August 4, 2005 from Wachovia Bank,
National Association. Previously filed in connection with the GSE
Systems, Inc. Form 10-Q filed with the Securities and Exchange
Commission on August 15, 2005, and incorporated herein by
reference.
14. Code of Ethics
14.1 Code of Ethics for Principal Executive Officer and Senior
Financial Officers, filed herewith.
21. Subsidiaries.
List of Subsidiaries of Registrant at December 31, 2005, filed
herewith.
23. Consents of Experts and Counsel
23.1 Consent of KPMG LLP, filed herewith.
24. Power of Attorney
24.1 Power of Attorney for Directors' and Officers' Signatures on SEC
Form 10-K, filed herewith.
31. Certifications
31.1 Certification of Chief Executive Officer of the Company pursuant
to Securities and Exchange Act Rule 13d-14(a)/15(d-14(a), as
adopted pursuant to Section 302 and 404 of the Sarbanes-Oxley Act
of 2002, filed herewith.
31.2.Certification of Chief Financial Officer of the Company pursuant
to Securities and Exchange Act Rule 13d-14(a)/15(d-14(a), as
adopted pursuant to Section 302 and 404 of the Sarbanes-Oxley Act
of 2002, filed herewith.
32. Section 1350 Certifications
32.1 Certification of Chief Executive Officer and Chief Financial
Officer of the Company pursuant to 18 U.S.C. Section 1350 as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, filed herewith.
99. Additional Exhibits
99.1 Form of Right of First Refusal Agreement. Previously filed in
connection with Amendment No. 3 to the GSE Systems, Inc. Form S-1
Registration Statement as filed with the Securities and Exchange
Commission on July 24, 1995 and incorporated herein by reference.
* Management contracts or compensatory plans required to be filed as
exhibits pursuant to Item 14 (c) of this report.