U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934 FOR THE
QUARTERLY PERIOD ENDING MARCH 31, 2002.
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: 333-84045
PREDICTIVE SYSTEMS, INC.
(Exact Name of Registrant as Specified in its Charter)
DELAWARE 13-3808483
---------------------------------- ---------------------------------------
(State or other Jurisdiction of (I.R.S. Employer Identification Number)
Incorporation or Organization)
19 WEST 44TH STREET, NEW YORK, NEW YORK 10036
(Address of Principal Executive Offices) (Zip Code)
(212) 659-3400
(Registrant's Telephone Number, Including Area Code)
Check whether the registrant: (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
As of May 10, 2002, there were 37,368,012 shares of the registrant's common
stock, $.001 par value per share, outstanding.
INDEX
PREDICTIVE SYSTEMS, INC. AND SUBSIDIARIES
Page
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PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Balance Sheets as of March 31, 2002
(unaudited) and December 31, 2001 ........................ 1
Consolidated Statements of Operations for the three
months ended March 31, 2002 and 2001 (unaudited).......... 2
Consolidated Statements of Cash Flows for the three months
ended March 31, 2002 and 2001 (unaudited) ................ 3
Notes to Consolidated Financial Statements (unaudited) ... 4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS ..................... 8
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK .................................................... 19
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS ........................................ 20
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS ................ 20
ITEM 3. DEFAULTS UPON SENIOR SECURITIES .......................... 20
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ...... 20
ITEM 5. OTHER INFORMATION ........................................ 20
ITEM 6. EXHIBITS AND REPORT ON FORM 8-K .......................... 20
ITEM 7. SIGNATURES ............................................... 20
PART 1. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
PREDICTIVE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
2002 2001
------------- -------------
(unaudited)
ASSETS
Current assets
Cash and cash equivalents $ 32,159,454 $ 41,277,867
Accounts receivable - net of allowance for
doubtful accounts of $2,332,606 and $2,606,361, respectively 9,234,925 10,124,399
Unbilled work in process 1,889,691 1,319,044
Inventory held for resale 1,740,236 2,205,986
Related party receivables 1,287,461 1,052,540
Receivables from employees and stockholders 64,576 61,526
Refundable income taxes 407,163 375,982
Prepaid expenses and other current assets 1,752,496 2,180,531
------------- -------------
Total current assets 48,536,002 58,597,875
Property and equipment - net of accumulated
depreciation and amortization of $5,105,647 and $4,587,357, respectively 6,040,207 6,323,100
Intangible assets - net of accumulated amortization of $26,151,566 and $25,171,316, respectively 35,262,672 36,242,922
Restricted cash 1,336,949 782,292
Other assets 780,118 547,103
------------- -------------
Total assets $ 91,955,948 $ 102,493,292
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable $ 3,999,259 $ 5,451,745
Accrued expenses and other current liabilities 9,358,482 11,469,090
Current portion of capital lease obligations 75,585 81,714
Deferred income 437,584 333,527
------------- -------------
Total current liabilities 13,870,910 17,336,076
------------- -------------
Noncurrent liabilities
Capital lease obligations 36,731 52,134
Deferred rent 200,080 165,251
Other long-term liabilities 3,000 3,000
------------- -------------
Total noncurrent liabilities 239,811 220,385
------------- -------------
Total liabilities 14,110,721 17,556,461
------------- -------------
Commitments and contingencies
Stockholders' equity
Common stock, $.001 par value, 200,000,000 shares authorized,
37,197,241 and 36,360,491 shares issued and outstanding 37,197 36,361
Additional paid-in capital 230,141,471 229,408,586
Deferred compensation (146,962) (182,581)
Accumulated deficit (152,642,989) (144,390,718)
Accumulated other comprehensive income 456,510 65,183
------------- -------------
Total stockholders' equity 77,845,227 84,936,831
------------- -------------
Total liabilities and stockholders' equity $ 91,955,948 $ 102,493,292
============= =============
The accompanying notes to consolidated financial statements are
an integral part of these consolidated balance sheets.
1
PREDICTIVE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended March 31
---------------------------------
2002 2001
------------ ------------
Revenues:
Professional services $ 14,105,923 $ 20,357,844
Client-related reimbursable expenses 401,161 580,506
Hardware and software sales 523,483 401,080
------------ ------------
Total revenues 15,030,567 21,339,430
------------ ------------
Cost of revenues:
Professional services 9,845,721 14,597,192
Client-related expenses 652,621 1,194,323
Hardware and software purchases 493,159 282,828
------------ ------------
Total cost of revenues 10,991,501 16,074,343
------------ ------------
Gross profit 4,039,066 5,265,087
------------ ------------
Sales and marketing 2,742,051 4,559,552
General and administrative 6,515,193 11,884,862
Depreciation and amortization 774,402 766,495
Intangibles amortization 980,250 6,374,779
Restructuring charges 933,502 640,948
Loss on long-term investment in related party -- 1,000,000
Noncash compensation expense 35,619 110,267
------------ ------------
Operating expenses 11,981,017 25,336,903
------------ ------------
Operating loss (7,941,951) (20,071,816)
Other income (expense):
Interest income, net 135,248 1,063,024
Other (expense) income (445,568) 21,885
------------ ------------
Net loss $ (8,252,271) $(18,986,907)
============ ============
Net loss per share - basic and diluted $ (0.22) $ (0.54)
============ ============
Weighted average shares outstanding - basic and diluted 36,980,895 34,973,653
============ ============
The accompanying notes to consolidated financial statements are an
integral part of these consolidated statements.
2
PREDICTIVE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Three Months Ended March 31
----------------------------------
2002 2001
------------ ------------
Cash flows from operating activities:
Net loss $ (8,252,271) $(18,986,907)
Adjustments to reconcile net loss to net cash used in operating activities:
Noncash compensation expense 35,619 110,267
Depreciation and amortization 1,754,652 7,141,274
Bad debt expense 10,257 677,159
Loss on long-term investment in related party -- 1,000,000
(Increase) decrease in-
Restricted cash (554,657) --
Accounts receivable 644,296 2,904,499
Unbilled work in process (570,647) 1,593,169
Inventory held for resale 465,750 --
Refundable income taxes (31,181) (99,979)
Prepaid expenses and other assets 199,578 (967,693)
(Decrease) increase in-
Accounts payable (1,452,486) (36,276)
Accrued expenses and other current liabilities (2,110,608) (2,364,084)
Deferred income 104,057 1,303,759
Deferred rent and other long-term liabilities 34,829 32,275
------------ ------------
Net cash used in operating activities (9,722,812) (7,692,537)
------------ ------------
Cash flows from investing activities:
Purchase of marketable securities, net (1,343) (1,098,925)
Payments to employees, net (12,802) (35,125)
Purchase of property and equipment, net (491,510) (1,019,898)
------------ ------------
Net cash used in investing activities (505,655) (2,153,948)
------------ ------------
Cash flows from financing activities:
Principal payments on capital leases (21,532) (45,500)
Proceeds from exercise of stock options 738,916 1,218,704
------------ ------------
Net cash provided by financing activities 717,384 1,173,204
------------ ------------
Effects of exchange rates 392,670 (280,145)
------------ ------------
Net decrease in cash (9,118,413) (8,953,426)
Cash and cash equivalents - beginning of period 41,277,867 80,058,791
------------ ------------
Cash and cash equivalents - end of period $ 32,159,454 $ 71,105,365
============ ============
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest $ 13,586 $ 11,883
============ ============
Taxes $ 33,098 $ 113,153
============ ============
The accompanying notes to consolidated financial statements are an
integral part of these consolidated statements.
3
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(1) BASIS OF PRESENTATION
The consolidated financial statements and accompanying financial information as
of March 31, 2002 and for the three months ended March 31, 2002 and 2001 are
unaudited and, in the opinion of management, include all adjustments (consisting
only of normal recurring adjustments) which the Company considers necessary for
a fair presentation of the financial position of the Company at such dates and
the operating results and cash flows for those periods. The financial statements
included herein have been prepared in accordance with generally accepted
accounting principles and the instructions of Form 10-Q and Rule 10-01 of
Regulation S-X. Accordingly, certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted. These financial
statements should be read in conjunction with the Company's audited financial
statements for the year ended December 31, 2001. Results for interim periods are
not necessarily indicative of results for the entire year.
(2) NET INCOME (LOSS) PER SHARE
Basic net income (loss) per share is computed by dividing net income (loss)
available to common stockholders by the weighted average number of shares
outstanding. Diluted net income (loss) per share reflects the potential dilution
that would occur if securities or other contracts to issue common stock were
exercised or converted into common stock, unless they are antidilutive.
The following table reconciles the numerator and denominator for the
calculation:
Three Months Ended
March 31
--------------------------------
2002 2001
------------ ------------
(unaudited)
Numerator -
Net loss $ (8,252,271) $(18,986,907)
------------ ------------
Denominator -
Denominator for basic and diluted earnings
per share - weighted average
shares outstanding 36,980,895 34,973,653
============ ============
Net loss per share -
Basic and diluted $ (0.22) $ (0.54)
============ ============
The conversion of 11,308,784 outstanding options was not considered for any
period presented as the effect would be anti-dilutive.
4
(3) COMPREHENSIVE INCOME (LOSS)
The Company adopted Statement of Financial Accounting Standards No. 130,
Reporting Comprehensive Income, which established standards for reporting and
displaying comprehensive income (loss) and its components. The components of
comprehensive income (loss) are as follows:
Three Months Ended
March 31
---------------------------------
2002 2001
------------ ------------
(unaudited)
Net loss $ (8,252,271) $(18,986,907)
Unrealized (loss) gain on
investments (1,343) 21,814
Foreign currency translation
adjustment 392,670 (280,145)
------------ ------------
Comprehensive loss $ (7,860,944) $(19,245,238)
============ ============
(4) RELATED PARTIES
The Company provides network consulting services to Cisco Systems, Inc.
("Cisco") pursuant to an existing agreement negotiated by the parties in an
arm's-length transaction. This agreement provides that if the Company gives more
favorable rates to another client it will inform Cisco and Cisco will have the
right to terminate this agreement. One of the Company's directors is also an
officer of Cisco. Additionally, in September 1999, the Company sold 1,242,000
shares of common stock to Cisco for $12.00 per share. For the three months ended
March 31, 2002 and 2001, the Company recorded revenues of approximately $15,000
and $393,000, respectively, from services performed for Cisco. As of March 31,
2002 amounts due from Cisco were $10,197. Such amount is included in related
party receivables. There were no amounts due from Cisco as of December 31, 2001.
The Company provides network consulting services to BellSouth Corporation
("BellSouth") pursuant to an existing agreement negotiated by both parties in an
arm's-length transaction. One of the Company's directors is also an officer of
BellSouth. For the three months ended March 31, 2002 and 2001, the Company
recorded revenues of $2.2 million and $3.8 million, respectively, from services
performed for BellSouth. As of March 31, 2002 and December 31, 2001, amounts due
from BellSouth were $1,092,817 and $994,322, respectively. Such amounts are
included in related party receivables.
The Company provides network consulting services to Riversoft PLC pursuant to an
agreement negotiated by both parties in an arm's-length transaction.
Additionally, the Company purchased approximately $500,000 of software inventory
from Riversoft in 2001. Two of the Company's directors served on Riversoft PLC's
Board of Directors, one of which served until December 19, 2001. One of the
directors is also a general partner for a venture capital firm, which owns
approximately 10% of Riversoft PLC. For the three months ended March 31, 2001,
the Company recorded revenues of $69,950 from services performed for Riversoft
PLC. No revenues were recorded for the three months ended March 31, 2002. As of
March 31, 2002 and December 31, 2001, amounts due from Riversoft PLC were $7,000
and $50,343, respectively. Such amounts are included in related party
receivables.
The Company and Science Application International Corporation (SAIC) provide
network and security consulting services to each other pursuant to existing
agreements negotiated by both parties in arm's-length transactions. For the
three months ended March 31, 2002 and 2001, revenues from SAIC were
approximately $77,000 and $106,000, respectively, and the Company incurred
approximately $4,000 and $26,000, respectively, in costs from consulting
services from SAIC. Additionally, SAIC provides the Company with various
services relating to alarm, telecommunications and IT support functions and the
Company rents certain of its office space from SAIC. For the three months ended
March 31, 2002 and 2001, the Company incurred approximately $179,000 and
$280,000, respectively, in expenses for such services and real estate rental. In
addition, the Company and SAIC license certain of their respective intellectual
property to the other. The Company believes that these transactions are on terms
that are no less favorable than those that could be obtained from unaffiliated
third parties. As of March 31, 2002, amounts due from SAIC were $177,447. There
were no amounts due from SAIC as of December 31, 2001.
Receivables from employees and stockholders represent short term lending to such
parties entered into in the normal course of business.
The Company's management believes that these transactions were entered into on a
basis that approximates fair value.
5
(5) RESTRUCTURING CHARGES
In February 2001, the Company's management foresaw the need to lower the
operating costs of the business given its near-term revenue projections.
Therefore, the Company established a plan that included the following: (1) a
reduction in its workforce for both domestic and international operations
related to professional consultant employees that had been underutilized for
several months and also to employees that held various management, sales and
administrative positions deemed to be duplicative functions; (2) the closing of
several domestic and international regional offices located in geographic areas
that no longer cost justified remaining open; and (3) the discontinuance of
electronic equipment leases and other expenses related to the reduction in
workforce.
In December 2001, the Company formed a strategic alliance with Riptech to
outsource its monitoring services provided by the managed security services
division. As a result of this alliance, the Company established a restructuring
plan that included the following: (1) a reduction of the Company's workforce;
(2) the write-off of equipment and software development costs associated with
the Company's security operations center which was no longer needed as a result
of the outsourcing; and (3) the incurrence of nonrecoverable costs to convert
clients to Riptech.
In January 2002, the Company's management foresaw the need to continue to lower
the operating costs of the business given continuing difficult market conditions
in the enterprise sector. Therefore, the Company established a 2002
restructuring plan that included the following: (1) a reduction in its workforce
for both domestic and international operations related to professional
consultant employees that had been underutilized for several months and also to
employees that held various management, sales and administrative positions
deemed to be duplicative functions; (2) the closing of additional domestic
regional offices located in geographic areas that no longer cost justified
remaining open; and (3) the discontinuance of electronic equipment leases and
other expenses related to the reduction in workforce.
For the three months ended March 31, 2002, the Company recorded restructuring
charges of $933,502 in connection with its 2002 restructuring plan. Such charges
consisted of $818,717 in severance benefits and other related expenses for a
reduction in headcount of 47 employees and $264,785 in exit costs related to
real estate and electronic equipment for the closing of domestic offices. These
charges were offset by $150,000 received for equipment written off to
restructuring charges in 2001 in connection with the outsourcing of the
Company's monitoring services provided as part of the managed security services
division. For the three months ended March 31, 2001, the Company recorded
restructuring charges of $640,948 in connection with its 2001 restructuring plan
primarily related to severance costs for a reduction in headcount of 79
employees. These charges have been reflected as operating expenses of the
Company. As of March 31, 2002 restructuring charges of $1,644,674 remained
unpaid and are included in accrued expenses and other current liabilities in the
accompanying balance sheet.
A summary of the restructuring charges for the three months ended March 31, 2002
were as follows:
Balance as Utilization Balance as
of 12/31/01 Expense Non-Cash Cash of 3/31/02
---------- ---------- ---------- ---------- ----------
Severance and other related costs $ 17,320 $ 818,717 $ -- $ 118,385 $ 717,652
Exit Costs 1,115,996 264,785 -- 839,544 541,237
Outsourcing monitoring services 722,224 (150,000) -- 186,439 385,785
---------- ---------- ---------- ---------- ----------
$1,855,540 $ 933,502 $ -- $1,144,368 $1,644,674
========== ========== ========== ========== ==========
(6) INDUSTRY SEGMENT INFORMATION
The Company's reportable segments are US Consulting, International Consulting,
and Managed Security Services. Revenues and profits in the US Consulting and
International Consulting segments are generated by providing the following
services: network design and engineering, network and systems management,
integrated customer service, performance management, information security, and
business integration services.
Revenues and profits in the Managed Security Services segment are generated by
providing the following services: response, threat advisory through Information
Sharing and Analysis Centers, and providing of Open Source Intelligence
programs.
The accounting policies of the segments are the same as those described in the
"Summary of Significant Accounting Policies." The Company evaluates the
performance of its segments based on their operating income (loss), which
represents segment revenues less direct costs of operation, excluding the
allocation of corporate expense. Identifiable assets of the operating segments
principally consist of net accounts receivable, unbilled work in process and
inventory held for resale. Accounts receivable and unbilled work in process for
US Consulting and Managed Security Services are managed on a combined basis. All
other identifiable assets not attributable to industry segments are included in
corporate assets. The Company does not track expenditures for long-lived assets
on a segment basis. The table below presents information on the revenues and
operating (loss) income for each segment for the three months ended March 31,
2002 and 2001, and items which reconcile segment operating (loss) income to the
Company's reported net loss.
6
Three Months Ended March 31
2002 2001
------------- -------------
(unaudited)
Revenues:
US Consulting $ 10,865,134 $ 17,510,505
International Consulting 2,214,234 1,794,553
Managed Security Services 1,951,199 2,034,372
------------- -------------
Total revenues 15,030,567 21,339,430
------------- -------------
Operating (loss) income:
US Consulting (37,036) (3,138,030)
International Consulting (62,846) (1,158,077)
Managed Security Services 11,936 (801,336)
------------- -------------
Total operating (loss) income (87,946) (5,097,443)
------------- -------------
Corporate expenses:
Sales and marketing (321,970) (659,368)
General and administrative (4,808,262) (5,422,516)
Depreciation and amortization (774,402) (766,495)
Intangibles amortization (980,250) (6,374,779)
Restructuring charges (933,502) (640,948)
Loss on long-term investment in related
party -- (1,000,000)
Noncash compensation expense (35,619) (110,267)
Interest income, net 135,248 1,063,024
Other (expense) income (445,568) 21,885
------------- -------------
Total corporate expenses (8,164,325) (13,889,464)
------------- -------------
Net loss $ (8,252,271) $ (18,986,907)
============= =============
Identifiable assets:
US Consulting and Managed Security Services $ 12,074,049 $ 24,229,464
International Consulting 2,078,264 2,220,332
Corporate 77,803,635 200,526,410
------------- -------------
Total identifiable assets $ 91,955,948 $ 226,976,206
============= =============
(7) EFFECTS OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In July 2001, the FASB issued Statement of Financial Accounting Standards No.
141, "Business Combinations" (SFAS 141) and No. 142, "Goodwill and Other
Intangible Assets" (SFAS 142). SFAS 141 requires all business combinations
initiated after June 30, 2001 to be accounted for using the purchase method.
Under SFAS 142, goodwill and intangible assets with indefinite lives are no
longer amortized but are reviewed annually (or more frequently if impairment
indicators arise) for impairment. Separable intangible assets that are not
deemed to have indefinite lives will continue to be amortized over their useful
lives (but with no maximum life). The amortization provisions of SFAS 142 apply
to goodwill and intangible assets acquired after June 30, 2001. The Company
adopted the provisions of SFAS 142 on January 1, 2002. As a result of such
adoption, the Company did not amortize goodwill and assembled workforce for the
three months ended March 31, 2002, which would have been approximately
$1,853,000. The Company recorded approximately $5,395,000 in amortization of
goodwill and assembled workforce for the three months ended March 31, 2001.
7
In August 2001, the FASB issued Statement of Financial Accounting Standard No.
143, "Accounting for Asset Retirement Obligations" (SFAS 143), which is
effective October 1, 2003. SFAS 143 requires, among other things, the accounting
and reporting of legal obligations associated with the retirement of long-lived
assets that result from the acquisition, construction, development or normal
operation of a long-lived asset. The Company is currently assessing, but has not
yet determined the effect, if any, of SFAS 143.
In August 2001, the FASB issued Statement of Financial Accounting Standard No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets" (SFAS
144). This statement supersedes SFAS No. 121 "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and Accounting
Principles Board Opinion No. 30 "Reporting Results of Operations - Reporting the
Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions". The Statement retains the
fundamental provisions of SFAS No. 121 for recognition and measurement of
impairment, but amends the accounting and reporting standards for segments of a
business to be disposed of. The provisions of this statement are required to be
adopted no later than fiscal years beginning after December 31, 2001, with early
adoption encouraged. The Company adopted the provisions of SFAS No. 144
effective January 1, 2002. There was no impact to the Company's results of
operations upon adoption.
On November 14-15, 2001, the Emerging Issues Task Force (EITF) of the FASB
concluded that reimbursements received for "out-of-pocket" expenses should be
classified as revenue, and correspondingly cost of services, in the income
statement. The new accounting treatment should be applied in financial reporting
periods (years) beginning as early as the March 2002 quarter. Upon application
of the pronouncement, comparative financial statements for prior periods must
also be reclassified in order to ensure consistency among all periods presented.
The Company adopted this pronouncement effective January 1, 2002 and has
separately disclosed the impact of adoption in the Statements of Operations.
(8) SUBSEQUENT EVENT
In the second quarter of 2002, the Company plans to reduce headcount by
approximately 35-55 employees in connection with its 2002 restructuring plan.
These employees will consist primarily of professional consultants and sales
personnel. In addition, the Company will close additional domestic regional
offices located in geographic areas that no longer cost justify remaining open.
The Company will record restructuring charges of approximately $1,600,000
million to $2,100,000 for severance payments and exit costs related to real
estate and electronic equipment in connection with these actions.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS RELATING TO FUTURE EVENTS AND
FUTURE PERFORMANCE OF THE COMPANY WITHIN THE MEANING OF SECTION 27A OF THE
SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934,
INCLUDING, WITHOUT LIMITATION, STATEMENTS REGARDING THE COMPANY'S EXPECTATIONS,
BELIEFS, INTENTIONS OR FUTURE STRATEGIES THAT ARE SIGNIFIED BY THE WORDS
EXPECTS, ANTICIPATES, INTENDS, BELIEVES OR SIMILAR LANGUAGE. ACTUAL RESULTS
COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN SUCH FORWARD-LOOKING
STATEMENTS. ALL FORWARD-LOOKING STATEMENTS INCLUDED IN THIS DOCUMENT ARE BASED
ON INFORMATION AVAILABLE TO THE COMPANY ON THE DATE HEREOF, AND THE COMPANY
ASSUMES NO OBLIGATION TO UPDATE ANY FORWARD LOOKING STATEMENTS. THE COMPANY
CAUTIONS INVESTORS THAT ITS BUSINESS AND FINANCIAL PERFORMANCE ARE SUBJECT TO
SUBSTANTIAL RISKS AND UNCERTAINTIES. IN EVALUATING THE COMPANY'S BUSINESS,
PROSPECTIVE INVESTORS SHOULD CAREFULLY CONSIDER THE INFORMATION SET FORTH BELOW
UNDER THE CAPTION "RISK FACTORS" IN ADDITION TO THE OTHER INFORMATION SET FORTH
HEREIN AND ELSEWHERE IN THE COMPANY'S OTHER PUBLIC FILINGS WITH THE SECURITIES
AND EXCHANGE COMMISSION.
Substantially all of our revenues are derived from professional services. We
provide network and security consulting services to our clients on either a
project outsource or collaborative consulting basis. We derive revenues from
these services on both a fixed-price, fixed-time basis and on a time-and-expense
basis. We also provide managed security services to our clients. We derive
revenues from these services on a subscription basis. We use our BusinessFirst
approach to estimate and propose prices for our fixed-price projects. The
estimation process accounts for standard billing rates particular to each
project, the client's technology environment, the scope of the project and the
project's timetable and overall technical complexity. A member of our senior
management team must approve all of our fixed-price proposals in excess of
$500,000. For these contracts, we recognize revenue using a
percentage-of-completion method primarily based on costs incurred. We make
provisions for estimated losses on uncompleted contracts on a
contract-by-contract basis and recognize such provisions in the period in which
the losses are determined. Professional services revenues for time-and-expense
based projects are recognized as services are performed. Revenues for
subscription-based contracts are recognized on a straight-line basis over the
period of service. Any payments received in advance of services performed are
recorded as deferred revenue. Our clients are generally able to reduce or cancel
their use of our professional services without penalty and with little or no
notice. We also derive limited revenues from the sale of hardware and software.
8
Since we recognize professional services revenues only when our consultants are
engaged on client projects, the utilization of our consultants is important in
determining our operating results. In addition, a substantial majority of our
operating expenses, particularly personnel and related costs, depreciation and
rent, are relatively fixed in advance of any particular quarter. As a result,
any underutilization of our consultants may cause significant variations in our
operating results in any particular quarter and could result in losses for such
quarter. Factors which could cause underutilization include:
- the reduction in size, delay in commencement, interruption or
termination of one or more significant projects;
- the completion during a quarter of one or more significant projects;
- the miscalculation of resources required to complete new or ongoing
projects; and
- the timing and extent of training, weather related shut-downs,
vacations and holidays.
Our cost of revenues consist of costs associated with our professional services
and hardware and software purchases. Costs of revenues associated with
professional services include compensation and benefits for our consultants and
project-related travel expenses. Costs of hardware and software purchases
consist of acquisition costs of third-party hardware and software resold.
In February 2001, the Company's management foresaw the need to lower the
operating costs of the business given its near-term revenue projections.
Therefore, the Company established a plan that included the following: (1) a
reduction in its workforce for both domestic and international operations
related to professional consultant employees that had been underutilized for
several months and also to employees that held various management, sales and
administrative positions deemed to be duplicative functions; (2) the closing of
several domestic and international regional offices located in geographic areas
that no longer cost justified remaining open; and (3) the discontinuance of
electronic equipment leases and other expenses related to the reduction in
workforce.
In December 2001, the Company formed a strategic alliance with Riptech to
outsource its monitoring services provided by the managed security services
division. As a result of this alliance, the Company established a restructuring
plan that included the following: (1) a reduction of the Company's workforce;
(2) the write-off of equipment and software development costs associated with
the Company's security operations center which was no longer needed as a result
of the outsourcing; and (3) the incurrence of nonrecoverable costs to convert
clients to Riptech.
In January 2002, the Company's management foresaw the need to continue to lower
the operating costs of the business given continuing difficult market conditions
in the enterprise sector. Therefore, the Company established a 2002
restructuring plan that included the following: (1) a reduction in its workforce
for both domestic and international operations related to professional
consultant employees that had been underutilized for several months and also to
employees that held various management, sales and administrative positions
deemed to be duplicative functions; (2) the closing of additional domestic
regional offices located in geographic areas that no longer cost justified
remaining open; and (3) the discontinuance of electronic equipment leases and
other expenses related to the reduction in workforce.
For the three months ended March 31, 2002, the Company recorded restructuring
charges of $933,502 in connection with its 2002 restructuring plan. Such charges
consisted of $818,717 in severance benefits and other related expenses for a
reduction in headcount of 47 employees and $264,785 in exit costs related to
real estate and electronic equipment for the closing of domestic offices. These
charges were offset by $150,000 received for equipment written off to
restructuring charges in 2001 in connection with the outsourcing of the
Company's monitoring services provided as part of the managed security services
division. For the three months ended March 31, 2001, the Company recorded
restructuring charges of $640,948 in connection with its 2001 restructuring plan
primarily related to severance costs for a reduction in headcount of 79
employees. These charges have been reflected as operating expenses of the
Company.
Given the decline in revenue related to the service provider customer base,
coupled with the continuing uncertainty in the professional network consulting
services marketplace, we believe that our quarterly revenue and operating
results are likely to vary significantly in the future and that period-to-period
comparisons of our operating results are not necessarily meaningful and should
not be relied on as indications of future performance.
9
Critical Accounting Policies and Estimates
This discussion and analysis of our financial condition and results of
operations are based on our consolidated financial statements that have been
prepared under generally accepted accounting principles. The preparation of
financial statements in conformity with generally accepted accounting principles
requires our management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and the disclosure of contingent
assets and liabilities at the date of the financial statements and the reported
amounts of revenue and expenses during the reporting period. Actual results
could materially differ from those estimates. We have disclosed all significant
accounting policies in note 2 to the consolidated financial statements included
in this Form 10-K. The consolidated financial statements and the related notes
thereto should be read in conjunction with the following discussion of our
critical accounting policies. Our critical accounting policies and estimates
are:
o Revenue recognition
o Valuation of goodwill, intangible assets and other long-lived
assets
Revenue Recognition. We currently recognize revenue from professional services.
As described below, significant management judgments and estimates must be made
and used in determining the amount of revenue recognized in any given accounting
period. Material differences may result in the amount and timing of our revenue
for any given accounting period depending upon judgments made by or estimates
utilized by management.
We recognize revenue for fixed price contracts in accordance with SOP 81-1,
"Accounting for Performance of Construction Type and Certain Production Type
Contracts" ("SOP 81-1"). When reliable estimates are available for the costs and
efforts necessary to complete the consulting services and those services do not
include contractual milestones or other acceptance criteria, we recognize
revenue under the percentage of completion method based upon input measures,
such as hours. When such estimates are not available, we defer all revenue
recognition until we have completed the contract and have no further obligations
to the customer. Under each arrangement, revenues are recognized when a
non-cancelable agreement has been signed and the customer acknowledges an
unconditional obligation to pay, the services have been delivered, there are no
uncertainties surrounding customer acceptance, the fees are fixed and
determinable, and collection is considered probable.
Valuation of Goodwill and Intangible Assets. We previously evaluated our
long-lived assets in accordance with SFAS No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of "
("SFAS No. 121"). Long-lived assets that are not identified with an impaired
asset are reviewed for impairment whenever events or changes in circumstances
indicate that the net carrying value of the asset may not be recoverable.
Certain circumstances included a deterioration of our financial resources, poor
economic trends within the market sector, or significant changes in our business
model. In such circumstances, the net carrying value of the asset was compared
to the undiscounted future cash flows of the business segment to which that
asset is attributable. Impairment losses were measured by the amount in which
the net carrying value of the assets exceeded the fair value.
In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other
Intangible Assets" ("SFAS No. 142"). SFAS 142 requires goodwill and other
intangible assets to be tested for impairment at least annually, and written off
when impaired, rather than being amortized as previously required. The Company
adopted the provisions of SFAS 142 effective January 1, 2002. As a result of
such adoption, the Company did not amortize goodwill and assembled workforce for
the three months ended March 31, 2002, which would have been approximately
$1,853,000. The Company recorded approximately $5,395,000 in amortization of
goodwill and assembled workforce for the three months ended March 31, 2001.
RESULTS OF OPERATIONS
Three Months Ended March 31, 2002 and 2001
REVENUES. Substantially all of our revenues are derived from fees for
professional services. Revenues decreased 29.6% to $15.0 million in the three
months ended March 31, 2002 from $21.3 million in the three months ended March
31, 2001. Revenues from professional services decreased 30.7% to $14.1 million
in the three months ended March 31, 2002 from $20.4 million in the three months
ended March 31, 2001. This decrease was primarily due to difficult market
conditions in the enterprise sector. Client-related reimbursable expenses
decreased to $401,000 in the three months ended March 31, 2002 from $581,000 in
the three months ended March 31, 2001. This decrease was primarily attributable
to the nature of the customer contracts. Revenues from hardware and software
sales increased 30.5% to $523,000 in the three months ended March 31, 2002 from
$401,000 in the three months ended March 31, 2001. This increase was primarily
due to an increase in client requests for hardware and software in connection
with professional services projects. During the three months ended March 31,
2002, BellSouth Corporation accounted for 15.4% of our revenues from
professional services. The number of our billable consultants decreased from
approximately 429 at March 31, 2001 to approximately 306 at March 31, 2002.
10
GROSS PROFIT. Gross profit decreased 23.3% to $4.0 million in the three months
ended March 31, 2002 from $5.3 million in the three months ended March 31, 2001.
As a percentage of revenues, gross profit increased to 26.9% in the three months
ended March 31, 2002 from 24.7% in the three months ended March 31, 2001. The
increase in gross profit as a percentage of revenues is a result of a decrease
in client-related expenses and a decrease in direct labor costs as a result of
reductions in billable headcount from 429 at March 31, 2001 to 306 at March 31,
2002 offset by a decrease in utilization of our consultants and lower margins
recognized on the sale of hardware and software to our clients. Cost of revenues
decreased 31.6% to $11.0 million in the three months ended March 31, 2002 from
$16.1 million in the three months ended March 31, 2001. This decrease in cost of
revenues was due primarily to a decrease in compensation and benefits paid to
consultants as a result of reductions in billable headcount in connection with
our restructuring plans.
SALES AND MARKETING EXPENSES. Sales and marketing expenses decreased 39.9% to
$2.7 million in the three months ended March 31, 2002 from $4.6 million in the
three months ended March 31, 2001. As a percentage of revenues, sales and
marketing expenses decreased to 18.2% in the three months ended March 31, 2002
from 21.4% in the three months ended March 31, 2001. The decrease in absolute
dollars was primarily due to an decrease of $1.2 million in compensation and
benefits paid due to reductions in headcount in connection with our
restructuring plans and a decrease of $308,000 in commissions paid as a result
of declining revenues for professional services and the merging of two separate
sales forces for US Consulting and Managed Security Services in 2002. The
remaining $400,000 decrease in sales and marketing expenses was a result of a
decrease in marketing expenses and other selling related expenditures.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased 45.2% to $6.5 million in the three months ended March 31, 2002 from
$11.9 million in the three months ended March 31, 2001. As a percentage of
revenues, general and administrative expenses decreased to 43.3% in the three
months ended March 31, 2002 from 55.7% in the three months ended March 31, 2001.
The decrease in absolute dollars was primarily due to a decrease of $2.9 million
in compensation and benefits costs as a result of reductions in headcount in
connection with our restructuring plans, a decrease of $680,000 in travel and
entertainment and training costs also as a result of reductions in headcount, a
decrease of $667,000 in bad debt expense, a decrease of $148,000 in facilities
and equipment leases, and a decrease in professional services and other
administrative costs of $986,000.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased 1.0% to
$774,000 in the three months ended March 31, 2002 from $766,000 in the three
months ended March 31, 2001.
INTANGIBLES AMORTIZATION. Amortization of intangibles decreased to $980,000 for
the three months ended March 31, 2002 from $6.4 million for the three months
ended March 31, 2001. For the three months ended March 31, 2002, the amount
consisted of amortization for intangible assets not deemed to have indefinite
lives pursuant to the provisions of SFAS 142 which was adopted effective January
1, 2002. Such intangible assets consisted of customer lists, tradenames and
developed technology. Intangibles amortization for the three months ended March
31, 2001 consisted of amortization for all intangible assets, including goodwill
and assembled workforce.
RESTRUCTURING CHARGES. For the three months ended March 31, 2002, we recorded
restructuring charges of approximately $934,000 in connection with our 2002
restructuring plan. Such charges consisted of $819,000 in severance benefits and
other related expenses for a reduction in headcount of 47 employees and $265,000
in exit costs related to real estate and electronic equipment for the closing of
domestic offices. These charges were offset by $150,000 received for equipment
written off to restructuring charges in 2001 in connection with the outsourcing
of the Company's monitoring services provided as part of the managed security
services division. For the three months ended March 31, 2001, we recorded
restructuring charges of approximately $641,000 in connection with our 2001
restructuring plan primarily related to severance costs for a reduction in
headcount of 79 employees.
LOSS ON LONG-TERM INVESTMENT IN RELATED PARTY. On March 22, 2001, Paradigm4,
Inc. filed for federal bankruptcy protection. This action created significant
uncertainty regarding our investment in Paradigm4. As a result, we recognized a
loss on our $1.0 million investment in Paradigm4 in the three months ended March
31, 2001.
NONCASH COMPENSATION EXPENSE. During 1999, the Company granted options to
purchase shares of common stock at exercises prices that were less than the fair
market value of the underlying shares of common stock, resulting in deferred
compensation. During 2000, related to the acquisitions of Synet and Global
Integrity, the Company issued options to Synet and Global Integrity
optionholders in exchange for their Synet and Global Integrity options,
respectively. The unvested portion of the Synet and Global Integrity options
resulted in deferred compensation. These transactions result in noncash
compensation expense over the period that these specific options vest. During
the three months ended March 31, 2002 and 2001, we recorded approximately
$36,000 and $110,000, respectively, of noncash compensation expense related to
these options. The decrease in noncash compensation expense is a result of the
cancellation of options as a result of reductions in headcount in connection
with our restructuring plans.
OTHER INCOME (EXPENSE). Other expense in the three months ended March 31, 2002
primarily consisted of foreign currency exchange rate losses related to the
settlement of transactions between our foreign subsidiaries. Other income in the
three months ended March 31, 2001 primarily consisted of interest income. The
decrease in other income was primarily due to a decrease in interest income as a
result of the utilization of cash and cash equivalents to fund current operating
needs and a general decline in interest rates.
11
LIQUIDITY AND CAPITAL RESOURCES. Since inception, we have financed our
operations through borrowings under short-term credit facilities, the sale of
equity securities and cash flows from operations. As of March 31, 2002, we had
approximately $32.2 million in cash and cash equivalents and $1.3 million in
restricted cash pursuant to certain operating lease agreements.
Net cash used in operating activities increased to $9.7 million for the three
months ended March 31, 2002 from $7.7 million for the three months ended March
31, 2001. We experienced a decrease in accounts payable and accrued expenses and
other current liabilities of approximately $3.6 million. Such decrease included
approximately $2.4 million paid for the purchase of software inventory for
resale of which approximately $1.7 million remained in inventory at March 31,
2002. We also experienced an increase in restricted cash of $550,000 related to
a new equipment operating lease entered into in the first quarter of 2002.
Unbilled receivables increased approximately $571,000 primarily in connection
with the sale of software inventory for resale. These net outflows of cash were
offset by net inflows of cash as a result of decreases in accounts receivable of
$644,000. The decrease in accounts receivable was primarily attributable to
increased collection efforts and declining revenues due to difficult market
conditions.
Net cash used in investing activities was $506,000 and $2.2 million,
respectively, for the three months ended March 31, 2002 and 2001. Capital
expenditures were $492,000 for the three months ended March 31, 2002 and $1.0
million for the three months ended March 31, 2001. Capital expenditures
consisted of computer equipment, office furniture and leasehold improvements in
connection with the investment in our infrastructure. For the three months ended
March 31, 2001, we used a net of $1.1 million for the purchase of marketable
securities.
Net cash provided by financing activities was $717,000 and $1.2 million,
respectively, for the three months ended March 31, 2002 and 2001. Cash provided
by financing activities primarily resulted from the receipt of proceeds from the
exercise of options and the sale of common stock in connection with our Employee
Stock Purchase Plan.
We have a demand loan facility, secured by a lien on all of our assets, under
which we may borrow up to the lesser of $5.0 million or 80.0% of our accounts
receivable. Amounts outstanding under the facility bear interest at the lender's
base rate which was 4.75% at of March 31, 2002. As of March 31, 2002, there were
no amounts outstanding under the facility.
Based on our current revenue projections, we believe that we will continue to be
cash flow negative until at least the end of the year. We believe that our
existing cash and cash equivalents will be sufficient to meet our anticipated
needs for working capital and capital expenditures for at least the next twelve
months. If cash generated from operations is insufficient to satisfy our
liquidity requirements, we may seek to sell additional equity or debt securities
or to obtain a credit facility. The sale of additional equity or convertible
debt securities could result in dilution to our stockholders. The incurrence of
indebtedness would result in increased fixed obligations and could result in
operating covenants that would restrict our operations. We cannot assure you
that financing will be available in amounts or on terms acceptable to us, if at
all.
Recent Accounting Pronouncements
In July 2001, the FASB issued Statement of Financial Accounting Standards No.
141, "Business Combinations" (SFAS 141) and No. 142, "Goodwill and Other
Intangible Assets" (SFAS 142). SFAS 141 requires all business combinations
initiated after June 30, 2001 to be accounted for using the purchase method.
Under SFAS 142, goodwill and intangible assets with indefinite lives are no
longer amortized but are reviewed annually (or more frequently if impairment
indicators arise) for impairment. Separable intangible assets that are not
deemed to have indefinite lives will continue to be amortized over their useful
lives (but with no maximum life). The amortization provisions of SFAS 142 apply
to goodwill and intangible assets acquired after June 30, 2001. The Company
adopted the provisions of SFAS 142 on January 1, 2002. As a result of such
adoption, the Company did not amortize goodwill and assembled workforce for the
three months ended March 31, 2002, which would have been approximately
$1,853,000. The Company recorded approximately $5,395,000 in amortization of
goodwill and assembled workforce for the three months ended March 31, 2001.
In August 2001, the FASB issued Statement of Financial Accounting Standard No.
143, "Accounting for Asset Retirement Obligations" (SFAS 143), which is
effective October 1, 2003. SFAS 143 requires, among other things, the accounting
and reporting of legal obligations associated with the retirement of long-lived
assets that result from the acquisition, construction, development or normal
operation of a long-lived asset. The Company is currently assessing, but has not
yet determined the effect, if any, of SFAS 143.
In August 2001, the FASB issued Statement of Financial Accounting Standard No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets" (SFAS
144). This statement supersedes SFAS No. 121 "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and Accounting
Principles Board Opinion No. 30 "Reporting Results of Operations - Reporting the
Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions". The Statement retains the
fundamental provisions of SFAS No. 121 for recognition and measurement of
impairment, but amends the accounting and reporting standards for segments of a
business to be disposed of. The provisions of this statement are required to be
adopted no later than fiscal years beginning after December 31, 2001, with early
adoption encouraged. The Company adopted the provisions of SFAS 144 effective
January 1, 2002. There was no impact to the Company's results of operations upon
adoption.
12
On November 14-15, 2001, the Emerging Issues Task Force (EITF) of the FASB
concluded that reimbursements received for "out-of-pocket" expenses should be
classified as revenue, and correspondingly cost of services, in the income
statement. The new accounting treatment should be applied in financial reporting
periods (years) beginning as early as the March 2002 quarter. Upon application
of the pronouncement, comparative financial statements for prior periods must
also be reclassified in order to ensure consistency among all periods presented.
The Company adopted this pronouncement effective January 1, 2002 and has
separately disclosed the impact of adoption in the Statements of Operations.
13
RISK FACTORS
An investment in our company involves a high degree of risk. You should
carefully consider the risks described below before you decide to buy our common
stock. If any of the following risks actually occur, our business, results of
operations or financial condition would likely suffer. In this case, the trading
price of our common stock could decline.
Risks Related to Our Financial Condition and Business Model
Our limited operating history makes it difficult for you to evaluate our
business and to predict our future success
We commenced operations in February 1995 and therefore have only a
limited operating history for you to evaluate our business. Because of our
limited operating history and the fact that many of our competitors have longer
operating histories, we believe that the prediction of our future success is
difficult. You should evaluate our chances of financial and operational success
in light of the risks, uncertainties, expenses, delays and difficulties
associated with operating a new business, many of which are beyond our control.
You should not rely on our historical results of operations as indications of
future performance. The uncertainty of our future performance and the
uncertainties of our operating in a new and volatile market increase the risk
that the value of your investment will decline.
Adverse market conditions, particularly those affecting the professional
services industry, may impair our operating results
Our results depend to a large extent on market conditions affecting the
technology industry in general and the telecommunications and enterprise sectors
in particular. Adverse market conditions in the sectors in which we operate
could delay buying decisions or cause projects to be deferred, reduced in scope
or discontinued. These sectors are experiencing a drastic downturn. We can not
predict how long this contraction will last, or the timing or strength of a
recovery, if any. If market conditions and corporate spending in these sectors
do not improve, our operating results will continue to suffer.
Because most of our revenues are generated from a small number of clients, our
revenues are difficult to predict and the loss of one client could significantly
reduce our revenues
During the three months ended March 31, 2002, BellSouth Corporation
accounted for approximately 15.4% of our revenues from professional services.
Our five largest clients accounted for approximately 43.3% of our revenues for
the three months ended March 31, 2002. For the year ended December 31, 2001, our
five largest clients accounted for approximately 40.6% of our revenues. If one
of our major clients discontinues or significantly reduces the use of our
services, we may not generate sufficient revenues to offset this loss of
revenues and our net loss will increase. In addition, the non-payment or late
payment of amounts due from a major client could adversely affect us. As of
March 31, 2002, the accounts receivable from BellSouth was approximately $1.1
million, which related to work performed in January through March 2002.
Our clients may terminate their contracts with us on short notice
Our services are often delivered pursuant to short-term arrangements
and most clients can reduce or cancel their contracts for our services without
penalty and with little or no notice. If a major client or a number of small
clients terminate our contracts or significantly reduce or modify their business
relationships with us, we may not be able to replace the shortfall in revenues.
Consequently, you should not predict or anticipate our future revenues based
upon the number of clients we have currently or the number and size of our
existing projects.
Our operating results may vary from quarter to quarter in future periods, and as
a result, we may fail to meet the expectations of our investors and analysts,
which may cause our stock price to fluctuate or decline
Our operating results have varied from quarter to quarter. Our operating
results may continue to vary as a result of a variety of factors. These factors
include:
o the loss of key employees;
o the development and introduction of new service offerings;
o reductions in our billing rates;
o the miscalculation of resources required to complete new or
ongoing projects;
o the utilization of our workforce;
14
o the ability of our clients to meet their payments obligations
to us; and
o the timing and extent of training.
Many of these factors are beyond our control. Accordingly, you should not
rely on quarter-to-quarter comparisons of our results of operations as an
indication of our future performance. In addition, our operating results may be
below the expectations of public market analysts or investors in some future
quarter. If this occurs, the price of our common stock is likely to decline.
We derive a substantial portion of our revenues from fixed-price projects, under
which we assume greater financial risk if we fail to accurately estimate the
costs of the projects
We derive a substantial portion of our revenues from fixed-price
projects. For the three months ended March 31, 2002 and the year ended December
31, 2001, fixed-price projects accounted for 43.4% and 48.2% of our revenue,
respectively. We assume greater financial risks on a fixed-price project than on
a time-and-expense based project. If we miscalculate the resources or time we
need for these fixed-price projects, the costs of completing these projects may
exceed the price, which could result in a loss on the project and a increase in
net loss. We recognize revenues from fixed-price projects based on our estimate
of the percentage of each project completed in a reporting period. To the extent
our estimates are inaccurate, the revenues and operating profits, if any, that
we report for periods during which we are working on a fixed-price project may
not accurately reflect the final results of the project and we would be required
to record an expense for these periods equal to the amount by which our revenues
were previously overstated.
Our operating results may fluctuate due to seasonal factors which could result
in greater than expected losses
Our results of operations may experience seasonal fluctuations as
businesses typically spend less on network management services during the summer
and year-end vacation and holiday periods. Additionally, as a large number of
our employees take vacation during these periods, our utilization rates during
these periods tend to be lower, which reduces our margins and operating income.
Accordingly, we may report greater than expected losses for these periods.
Our long sales cycle makes our revenues difficult to predict and could cause our
quarterly operating results to be below the expectations of public market
analysts and investors
The timing of our revenues is difficult to predict because of the
length and variance of the time required to complete a sale. Before hiring us
for a project, our clients often undertake an extensive review process and may
require approval at various levels within their organization. Any delay due to a
long sales cycle could reduce our revenues for a quarter and cause our quarterly
operating results to be below the expectations of public market analysts or
investors. If this occurs, the price of our common stock is likely to decline.
We may need to raise additional capital to grow our business, which we may not
be able to do
Our future liquidity and capital requirements are difficult to predict
because they depend on numerous factors, including the success of our existing
and new service offerings and competing technological and market developments.
As a result, we may not be able to generate sufficient cash from our operations
to meet additional working capital requirements, support additional capital
expenditures or take advantage of acquisition opportunities. Accordingly, we may
need to raise additional capital in the future. Our ability to obtain additional
financing will be subject to a number of factors, including market conditions,
our operating performance and investor sentiment. These factors may make the
timing, amount, terms and conditions of additional financing unattractive for
us. If we are unable to raise additional funds when needed, our ability to
operate and grow our business could be impeded.
Risks Related to Our Strategy and Market
We may have difficulty managing our expanding operations, which may harm our
business
A key part of our strategy is to grow our business; however, our rapid
growth has placed a significant strain on our managerial and operational
resources. From January 1, 1999 to December 31, 2000, our headcount increased
from approximately 138 to approximately 691 employees. Since such time, as a
result of market conditions and other factors, we have decreased our headcount
to 401 employees as of March 31, 2002. As a result of this reduction, the
remaining employees have been charged with additional responsibilities. To
manage our growth, we must continue to improve our financial and management
controls, reporting systems and procedures, and expand and train our work force.
We may not be able to do so successfully.
15
The workforce restructuring we have taken in response to the recent slowdown in
demand for our services could have adverse effects on our business.
Our business has been experiencing lower revenues due to decreased
customer demand for our services. To scale back our operations and to reduce our
expenses in response to this decreased demand for our services, we have
significantly reduced the size of our workforce. While these actions have
positively impacted our results of operations, there are several risks inherent
in our efforts to transition to a smaller workforce. Reducing the size of our
workforce could have adverse effects on our business by reducing our pool of
technical talent, making it more difficult for us to respond to customers,
limiting our ability to provide increased services quickly if and when the
demand for our services increases, and limiting our ability to hire and retain
key personnel. These circumstances could cause our earnings to be lower than
they might otherwise be.
Our management team has experienced significant turnover which could interrupt
our business and adversely affect our growth
Our future success depends, in significant part, upon the continued
service and performance of our senior management and other key personnel. Andrew
Zimmerman was appointed our Chief Executive Officer in June 2001 and Neeraj
Sethi has just been recently appointed Acting Chief Financial Officer while a
search is conducted for permanent replacement. In addition, in connection with
our recent reductions in staff, many members of our senior management team have
either departed, or been redeployed and given new responsibilities. If the
restructuring of our senior management team does not lead to the results we
expect, our ability to effectively deliver our services, manage our company and
carry out our business plan may be impaired.
We may not be able to hire and retain qualified network systems and security
consultants which could affect our ability to compete effectively
Our continued success depends on our ability to identify, hire, train
and retain highly qualified network and security management consultants. These
individuals are in high demand and we may not be able to attract and retain the
number of highly qualified consultants that we need. If we cannot retain,
attract and hire the necessary consultants, our ability to grow, complete
existing projects and bid for new projects will be adversely affected.
Competition in the network and security consulting industry is intense, and
therefore we may lose projects to our competitors
Our market is intensely competitive, highly fragmented and subject to
rapid technological change. We expect competition to intensify and increase over
time. We may lose projects to our competitors, which could adversely affect our
business, results of operations and financial condition. In addition,
competition could result in lower billing rates and gross margins and could
require us to increase our spending on sales and marketing.
We face competition from systems integrators, value added resellers,
network services firms, security consulting firms, telecommunications providers,
and network equipment and computer systems vendors. These competitors may be
able to respond more quickly to new or emerging technologies and changes in
client requirements or devote greater resources to the expansion of their market
share.
Additionally, our competitors have in the past and may in the future
form alliances with various network equipment vendors that may give them an
advantage in implementing networks using that vendor's equipment.
We also compete with internal information technology departments of
current and potential clients. To the extent that current or potential clients
decide to satisfy their needs internally, our business will suffer.
If we are unable to find suitable acquisition candidates, our growth could be
impeded
A component of our growth strategy is the acquisition of, or investment
in, complementary businesses, technologies, services or products. Our ability to
identify and invest in suitable acquisition and investment candidates on
acceptable terms is crucial to this strategy. We may not be able to identify,
acquire or make investments in promising acquisition candidates on acceptable
terms. Moreover, in pursuing acquisition and investment opportunities, we may be
in competition with other companies having similar growth and investment
strategies. Competition for these acquisitions or investment targets could also
result in increased acquisition or investment prices and a diminished pool of
businesses, technologies, services or products available for acquisition or
investment.
Our acquisition strategy could have an adverse effect on client satisfaction and
our operating results
Acquisitions, including those already consummated, involve a number of
risks, including:
o integrating the acquired company into our existing business;
o adverse effects on our reported operating results due to
accounting charges associated with acquisitions;
o increased expenses, including compensation expense resulting
from newly hired employees; and
o potential disputes with the sellers of acquired businesses,
technologies, services or products.
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Client dissatisfaction or performance problems with an acquired business,
technology, service or product could also have a material adverse impact on our
reputation as a whole. In addition, any acquired business, technology, service
or product could significantly underperform relative to our expectations.
Competition for experienced personnel is intense and our inability to retain key
personnel could interrupt our business and adversely affect our growth
Our future success depends, in significant part, upon the continued
service and performance of our senior management and other key personnel. Losing
the services of any of these individuals may impair our ability to effectively
deliver our services and manage our company, and to carry out our business plan.
In addition, competition for qualified personnel in the network and security
consulting industry is intense and we may not be successful in attracting and
retaining these personnel. There may be only a limited number of persons with
the requisite skills to serve in these positions and it may become increasingly
difficult to hire these persons. Our business will suffer if we encounter delays
in hiring additional personnel.
Our business may suffer if we fail to adapt appropriately to the challenges
associated with operating internationally
Operating internationally may require us to modify the way we conduct
our business and deliver our services in these markets. We anticipate that we
will face the following challenges internationally:
o the burden and expense of complying with a wide variety of
foreign laws and regulatory requirements;
o potentially adverse tax consequences;
o longer payment cycles and problems in collecting accounts
receivable;
o technology export and import restrictions or prohibitions;
o tariffs and other trade barriers;
o difficulties in staffing and managing foreign operations;
o cultural and language differences;
o fluctuations in currency exchange rates; and
o seasonal reductions in business activity during the summer
months in Europe.
If we do not appropriately anticipate changes and adapt our practices to
meet these challenges, our growth could be impeded and our results of operations
could suffer.
If we do not keep pace with technological changes, our services may become less
competitive and our business will suffer
Our market is characterized by rapidly changing technologies, frequent
new product and service introductions, and evolving industry standards. As a
result of the complexities inherent in today's computing environments, we face
significant challenges in remaining abreast of such changes and product
introductions. If we cannot keep pace with these changes, we will not be able to
meet our clients' increasingly sophisticated network management and security
needs and our services will become less competitive.
Our future success will depend on our ability to:
o keep pace with continuing changes in industry standards,
information technology and client preferences;
o respond effectively to these changes; and
o develop new services or enhance our existing services.
We may be unable to develop and introduce new services or enhancements to
existing services in a timely manner or in response to changing market
conditions or client requirements.
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If the use of large-scale, complex networks does not continue to grow, we may
not be able to successfully increase or maintain our client base and revenues
To date, a majority of our revenues have been from network management
and security services related to large-scale, complex networks. We believe that
we will continue to derive a majority of our revenues from providing network
design, performance, management and security services. As a result, our future
success is highly dependent on the continued growth and acceptance of
large-scale, complex computer networks and the continued trend among our clients
to use third-party service providers. If the growth of the use of enterprise
networks does not continue or declines, our business may not grow and our
revenues may decline.
Risks Related to Intellectual Property Matters and Potential Legal Liability
Unauthorized use of our intellectual property by third parties may damage our
brand
We regard our copyrights, trade secrets and other intellectual property
as critical to our success. Unauthorized use of our intellectual property by
third parties may damage our brand and our reputation. We rely on trademark and
copyright law, trade secret protection and confidentiality and/or license and
other agreements with our employees, customers, partners and others to protect
our intellectual property rights. However existing trade secret, trademark and
copyright laws afford us only limited protection. Despite our precautions, it
may be possible for third parties to obtain and use our intellectual property
without our authorization. The laws of some foreign countries are also uncertain
or do not protect intellectual property rights to the same extent as do the laws
of the United States.
We may have to defend against intellectual property infringement claims, which
could be expensive and, if we are not successful, could disrupt our business
We cannot be certain that our services, the finished products that we
deliver or materials provided to us by our clients for use in our finished
products do not or will not infringe valid patents, copyrights, trademarks or
other intellectual property rights held by third parties. As a result, we may be
subject to legal proceedings and claims from time to time relating to the
intellectual property of others in the ordinary course of our business. We may
incur substantial expenses in defending against these third-party infringement
claims, regardless of their merit. Successful infringement claims against us may
result in substantial monetary liability and materially disrupt the conduct of
our business.
Because our services are often critical to our clients' operations, we may be
subject to significant claims if our services do not meet our clients
expectations
Many of our projects are critical to the operations of our clients'
businesses. If we cannot complete these projects to our clients' expectations,
we could materially harm our clients' operations. This could damage our
reputation, subject us to increased risk of litigation or result in our having
to provide additional services to a client at no charge. Although we carry
general liability insurance coverage, our insurance may not cover all potential
claims to which we are exposed or may not be adequate to indemnify us for all
liability that may be imposed.
Our stock price is likely to be highly volatile and could drop unexpectedly
The market price of our common stock is highly volatile, has fluctuated
substantially and may continue to do so. As a result, investors in our common
stock may experience a decrease in the value of their common stock regardless of
our operating performance or prospects. In addition, the stock market has, from
time to time, experienced significant price and volume fluctuations that have
affected the market prices for the securities of technology companies. Should
our stock trade below $1.00 per share for a significant period of time, we may
not be in compliance with Nasdaq listing requirements, which could lead to our
stock being delisted from Nasdaq. In the past, following periods of volatility
in the market price of a particular company's securities, securities class
action litigation was often brought against that company. Many
technology-related companies have been subject to this type of litigation. We
are currently involved in this type of litigation. Litigation is often expensive
and diverts management's attention and resources.
Matters relating to Arthur Andersen, our independent public accountants, may
lead to adverse consequences for us.
Our independent certified public accountant, Arthur Andersen LLP, has
informed us that on March 14, 2002, it was indicted on federal obstruction of
justice charges arising from the government's investigation of Enron Corp.
Arthur Andersen has indicated that it intends to contest vigorously the
indictment. Our audit committee has been carefully monitoring the situation. As
a public company, we will be required to file with the SEC periodic financial
statements audited or reviewed by an independent, certified public accountant.
The SEC has said that it will continue accepting financial statements audited or
reviewed by Arthur Andersen so long as Arthur Andersen is able to make certain
representations to us. Our access to the capital markets and our ability to make
timely SEC filings could be impaired if the SEC ceases accepting financial
statements audited by Arthur Andersen, if Arthur Andersen becomes unable to make
the required representations to us or if for any other reason Arthur Andersen is
unable to perform accounting services for us. In such case, we would promptly
seek to engage new independent certified public accountants or take such actions
necessary for us to maintain access to the capital markets and timely financial
reporting. These events could cause us to incur costs and delays in financial
reporting. Further, it is possible that events arising out of the indictment may
adversely effect the ability of Arthur Andersen to satisfy any claims arising
from its provision of auditing and other services to us, including claims that
may arise out of Arthur Andersen's audit of our financial statements.
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We are controlled by a small group of our existing stockholders, whose interests
may differ from other stockholders
Our directors, executive officers and affiliates currently beneficially
own approximately 29% of the outstanding shares of our common stock.
Accordingly, these stockholders will have significant influence in determining
the outcome of any corporate transaction or other matter submitted to the
stockholders for approval, including mergers, acquisitions, consolidations and
the sale of all or substantially all of our assets, and also the power to
prevent or cause a change in control. The interests of these stockholders may
differ from the interests of the other stockholders.
Our charter documents and Delaware law may inhibit a takeover that stockholders
may consider favorable
Provisions in our charter and bylaws may have the effect of delaying or
preventing a change of control or changes in our management that stockholders
consider favorable or beneficial. If a change of control or change in management
is delayed or prevented, the market price of our common stock could decline.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Currency Rate Fluctuations.
Our results of operations, financial position and cash flows are not materially
affected by changes in the relative values of non-U.S. currencies to the U.S.
dollar. We do not use derivative financial instruments to limit our foreign
currency risk exposure.
Market Risk.
Our accounts receivable are subject, in the normal course of business, to
collection risks. We regularly assess these risks and have established policies
and business practices to protect against the adverse effects of collection
risks. As a result, we do not anticipate any material losses in this area.
Interest Rate Risks.
We do not currently have any outstanding indebtedness. In addition, our
investments are classified as cash and cash equivalents with original maturities
of three months or less. Therefore, we are not exposed to material market risk
arising from interest rate changes, nor do such changes affect the value of
investments as recorded by us.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Except as set forth below, we are not a party to any material legal proceedings.
On November 13, 2001, a securities class action complaint was filed in
the United States District Court for the Southern District of New York against
certain investment banks that underwrote our initial public offering,
Predictive, and certain of our officers and directors. This action has been
coordinated with over 300 virtually identical actions against other companies
and the investment banks that underwrote their initial public offerings. The
complaint filed against us generally alleges that the underwriters obtained
excessive and undisclosed commissions from customers who received allocations of
shares in our initial and secondary public offerings and that the underwriters
maintained artificially inflated prices in the after market through "tie-in"
arrangements, which required customers to buy additional shares of our stock at
pre-determined prices in excess of the offering prices. The complaint further
alleges that we and our officers and directors violated Sections 11, 12(2), and
15 of the Securities Act of 1933 because our registration statements did not
disclose the purported misconduct of the underwriters. Plaintiffs seek an
unspecified amount of damages on behalf of persons who purchased our stock
pursuant to the registration statements. We believe that the allegations against
us are without merit and intend to defend the case vigorously.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
NONE.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
NONE.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
NONE.
ITEM 5. OTHER INFORMATION
NONE
ITEM 6. EXHIBITS AND REPORT ON FORM 8-K
(a) No Exhibits
(b) The Company did not file any reports on Form 8-K during the three months
ended March 31, 2002.
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ITEM 7. SIGNATURES
Pursuant to the requirements of the Securities Exchange Act, the Registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
PREDICTIVE SYSTEMS, INC.
(Registrant)
Date: May 14, 2002 /s/ ANDREW ZIMMERMAN
------------------------------- ---------------------------------------
Name: Andrew Zimmerman
Title: Chief Executive Officer
(principal executive officer)
Date: May 14, 2002 /s/ NEERAJ SETHI
---------------------------------- --------------------------------------
Name: Neeraj Sethi
Title: Acting Chief Financial Officer
(principal accounting and
financial officer)