FORM 10-Q
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 27, 1996
Commission file number 0-28352
TECHNOLOGY SERVICE GROUP, INC.
(Exact name of Registrant as specified in its charter)
Delaware 59-1637426
(State or other jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
20 Mansell Court East - Suite 200 30076
Roswell, Georgia (Zip Code)
(Address of principal executive offices)
(770) 587-0208
(Registrant's Telephone Number,
including area code)
Indicate by check mark whether 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 ___
At November 1, 1996, there were 4,694,250 shares of common stock, $.01 par
value, outstanding.
<PAGE>
INDEX
Page
Number
------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets at September 27, 1996
(unaudited) and March 29, 1996 3
Consolidated Statements of Operations for the
three months and six months ended September 27, 1996
(unaudited) and September 29, 1995 (unaudited) 4
Consolidated Statements of Cash Flows for the
six months ended September 27, 1996 (unaudited) and
September 29, 1995 (unaudited) 5
Consolidated Statement of Changes in Stockholders'
Equity for the six months ended September 27, 1996
(unaudited) 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 12
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 25
Item 2. Exhibits and Reports on Form 8-K 25
2
<PAGE>
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
TECHNOLOGY SERVICE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
SEPTEMBER 27, MARCH 29,
1996 1996
------------ ------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Current assets:
Cash $ 157,365 $ 19,787
Accounts receivable, less allowance for doubtful
accounts of $272,000 and $216,000 2,954,596 3,866,372
Inventories 13,635,212 8,658,669
Deferred tax asset 425,277 50,544
Prepaid expenses and other current assets 127,655 146,117
------------ ------------
Total current assets 17,300,105 12,741,489
Property and equipment, net 1,955,084 2,198,625
Deferred tax asset 145,312 --
Other assets 3,775,747 4,693,650
------------ ------------
$ 23,176,248 $ 19,633,764
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Bank overdraft $ 1,033,672 $ 1,002,403
Borrowings under revolving credit agreement 1,795,377 --
Current maturities under long-term debt and
capital lease obligations 47,905 118,444
Accounts payable 4,418,745 5,030,945
Income taxes payable 396,478 165,666
Deferred revenue -- 541,245
Accrued liabilities 1,107,883 1,472,379
Accrued restructuring charges 78,927 16,427
------------ ------------
Total current liabilities 8,878,987 8,347,509
Borrowings under revolving credit agreement -- 1,093,735
Long-term debt and capital lease obligations 890,666 3,414,586
Notes payable to stockholders -- 2,800,000
Deferred revenue 375,000 375,000
Other liabilities 3,198 3,198
------------ ------------
10,147,851 16,034,028
------------ ------------
Commitments and contingencies -- --
Stockholders' equity:
Preferred stock, $100 par value, 100,000 authorized,
none issued or outstanding -- --
Common stock, $.01 par value, 10,000,000 shares authorized,
4,693,750 and 3,500,000 shares issued and outstanding 46,938 35,000
Capital in excess of par value 11,912,987 3,465,000
Retained earnings 1,082,259 111,790
Cumulative translation adjustment (13,787) (12,054)
------------ ------------
Total stockholders' equity 13,028,397 3,599,736
------------ ------------
$ 23,176,248 $ 19,633,764
============ ============
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
3
<PAGE>
TECHNOLOGY SERVICE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
---------------------------- ----------------------------
September 27, September 29, September 27, September 29,
1996 1995 1996 1995
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Net sales $ 10,061,718 $ 7,737,680 $ 22,140,214 $ 14,091,825
------------ ------------ ------------ ------------
Costs and expenses:
Cost of goods sold 7,769,914 6,145,900 17,610,363 11,441,027
General and administrative expenses 717,871 544,257 1,362,856 1,078,615
Marketing and selling expenses 193,630 321,928 555,108 586,652
Engineering, research and
development expenses 655,526 265,611 1,064,621 552,040
Litigation settlement -- -- (105,146) --
Interest expense 63,047 231,304 204,587 437,889
Restructuring charges 62,500 -- 62,500 --
Other (income) expense (13,413) (7,424) (29,600) (9,844)
------------ ------------ ------------ ------------
9,449,075 7,501,576 20,725,289 14,086,379
------------ ------------ ------------ ------------
Income (loss) before income tax
expense 612,643 236,104 1,414,925 5,446
Income tax provision (227,254) -- (444,456) --
------------ ------------ ------------ ------------
Net income (loss) $ 385,389 $ 236,104 $ 970,469 $ 5,446
============ ============ ============ ============
Income (loss) per common and
common equivalent share:
Primary $ 0.08 $ 0.06 $ 0.21 $ --
============ ============ ============ ============
Assuming full dilution $ 0.08 $ 0.06 $ 0.21 $ --
============ ============ ============ ============
Weighted average number of common and
common equivalent shares outstanding:
Primary 5,007,791 3,805,625 4,726,809 3,805,625
============ ============ ============ ============
Assuming full dilution 5,007,791 3,805,625 4,726,809 3,805,625
============ ============ ============ ============
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
4
<PAGE>
TECHNOLOGY SERVICE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Six Months Ended
---------------------------
September 27, September 29,
1996 1995
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 970,469 $ 5,446
Adjustments to reconcile net income (loss) to net
cash provided by (used for) operating activities
Depreciation and amortization 579,021 506,441
Provisions for inventory losses and
warranty expense 340,481 103,183
Provision for uncollectible accounts receivable 55,999 34,949
Restructuring charges 62,500 --
Provision for deferred tax benefits (133,905) --
Changes in certain assets and liabilities
(Increase) decrease in accounts receivable 855,777 (1,433,290)
(Increase) in inventories (5,189,527) (452,803)
Decrease in prepaid expenses and
other current assets 18,462 29,163
(Increase) in other assets (607) (6,934)
Increase (decrease) in accounts payable (612,199) 720,481
Increase in income taxes payable 284,317 --
(Decrease) in deferred revenue (541,245) --
(Decrease) in accrued liabilities (491,993) (103,665)
(Decrease) in accrued restructuring charges -- (60,000)
Other 792 (576)
----------- -----------
Net cash used for operating activities (3,801,658) (657,605)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures (197,512) (132,206)
----------- -----------
Net cash used for investing activities (197,512) (132,206)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds under revolving credit
agreement 701,642 647,952
Proceeds from initial public offering, net of
issuance expenses 8,634,547 --
Proceeds from exercise of common stock
options and warrants 163,750 --
Repayment of notes payable to stockholders (2,800,000) --
Principal payments on long-term debt and
capital lease obligations (2,594,460) (496,303)
Increase in bank overdraft 31,269 402,412
----------- -----------
Net cash provided by financing
activities 4,136,748 554,061
----------- -----------
Increase (decrease) in cash 137,578 (235,750)
Cash, beginning of period 19,787 265,576
----------- -----------
Cash, end of period $ 157,365 $ 29,826
=========== ===========
The accompanying notes are an integral part of these
consolidated financial statements.
5
<PAGE>
TECHNOLOGY SERVICE GROUP, INC.
STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE SIX MONTHS ENDED SEPTEMBER 27, 1996
(Unaudited)
<TABLE>
<CAPTION>
Capital in Cummulative
Common Excess of Retained Translation
Stock Par Value Earnings Adjustment Total
------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Balance at March 29, 1996 $ 35,000 $ 3,465,000 $ 111,790 $ (12,054) $ 3,599,736
Issuance of 1,150,000 shares in
initial public offering, net of
issuance expenses 11,500 8,284,675 -- -- 8,296,175
Issuance of 40,000 shares upon
exercise of common stock
purchase warrants 400 159,600 -- -- 160,000
Issuance of 3,750 shares upon
exercise of common stock
options 38 3,712 -- -- 3,750
Net income for the period -- -- 970,469 -- 970,469
Foreign currency translation
adjustment -- -- -- (1,733) (1,733)
============ ============ ============ ============ ============
Balance at September 27, 1996 $ 46,938 $ 11,912,987 $ 1,082,259 $ (13,787) $ 13,028,397
============ ============ ============ ============ ============
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
6
<PAGE>
TECHNOLOGY SERVICE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. GENERAL
The accompanying unaudited consolidated balance sheet of the Company as of
September 27, 1996 and the related unaudited consolidated statements of
operations for the three months and six months ended September 27, 1996 and
September 29, 1995, and the unaudited consolidated statements of cash flows and
statement of changes in stockholders' equity for the six months ended September
27, 1996 have been prepared in accordance with instructions to Form 10-Q.
Accordingly, the financial information does not include all the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments, consisting
only of normal recurring accruals and adjustments, necessary for a fair
presentation of the financial position of the Company at September 27, 1996 and
its operations and its cash flows for the three months and six months ended
September 27, 1996 and September 29, 1995 have been made. For further
information, refer to the audited financial statements and footnotes included in
the Company's annual report on Form 10-K for the fiscal year ended March 29,
1996.
The results of operations for the three months and six months ended
September 27, 1996 are not necessarily indicative of the results for the entire
fiscal year ending March 28, 1997.
2. INVENTORIES
Inventories at September 27, 1996 and March 29, 1996 consisted of the
following:
September 27, March 29,
1996 1996
----------- -----------
Raw materials $ 7,050,708 $ 6,056,702
Work-in-process 4,236,267 1,207,080
Finished goods 2,348,237 1,394,887
----------- -----------
$13,635,212 $ 8,658,669
=========== ===========
3. BORROWINGS UNDER REVOLVING CREDIT AGREEMENT, LONG-TERM DEBT, CAPITAL LEASE
OBLIGATIONS AND NOTES PAYABLE TO STOCKHOLDERS
At September 27, 1996, the Company is able to borrow up to a maximum of $9
million under a revolving credit agreement pursuant to the terms of a Loan and
Security Agreement (the "Loan Agreement") between the Company and its bank. At
September 27, 1996 and March 29, 1996, the Company had outstanding debt of
$1,795,377 and $1,093,735, respectively, under the revolving credit agreement.
At March 29, 1996, the Company also had outstanding debt of $2,525,000 under
term and installment notes issued pursuant to the terms of the Loan Agreement.
Indebtedness outstanding under the Loan Agreement is secured by substantially
all assets of the Company including accounts receivable, inventories and
property and equipment. At September 27, 1996, the borrowing limit under the
revolving credit agreement was based upon specified percentages applied to the
value of collateral, consisting of accounts receivable and inventories. At March
29, 1996, the borrowing limit under the revolving credit agreement was based
upon specified percentages applied to the value of collateral less indebtedness
outstanding under a $2.2 million term note due November 30, 1997. Interest is
payable monthly at a variable rate per annum equal to 1.5% above a base rate
quoted by Citibank (8.25% at September 27, 1996 and March 29, 1996).
7
<PAGE>
In May 1996, the Company completed an initial public offering of equity
securities (see Note 4). A portion of the proceeds from the initial public
offering was used to repay the Company's then outstanding indebtedness of
$2,509,524 pursuant to the term and installment notes. In addition, a portion of
the proceeds was used to repay $3,808,589 of indebtedness outstanding under the
revolving credit agreement. Accordingly, the Company classified $1,093,735 of
indebtedness outstanding under the revolving credit agreement and $2,509,524 of
indebtedness outstanding under term and installment notes at March 29, 1996 as
long-term obligations.
Long-term debt and capital lease obligations payable at September 27, 1996
and March 29, 1996 consisted of the following:
September 27, March 29,
1996 1996
----------- -----------
Loan and Security Agreement
$2.2 million secured term note, principal
balance due November 30, 1997 $ -- $ 2,200,000
$650,000 secured term note, principal
payable in sixty equal monthly installments
of $7,738, with remaining principal balance
due November 30, 1997 -- 325,000
Unsecured non-interest bearing promissory
note, payable in nineteen equal monthly
installments of $10,873 -- 32,620
Obligations under capital leases 938,571 975,410
----------- -----------
938,571 3,533,030
Less - current maturities (47,905) (118,444)
----------- -----------
$ 890,666 $ 3,414,586
=========== ===========
On October 31, 1994, the Company entered into an Investment Agreement.
Pursuant to the terms of the Investment Agreement, the Company borrowed $2.8
million from stockholders and issued subordinated promissory notes due November
30, 1999 that bear interest at a rate of 10% per annum. In May 1996, the Company
repaid the outstanding indebtedness pursuant to the subordinated promissory
notes from the proceeds of its initial public offering.
4. STOCKHOLDERS' EQUITY
Initial Public Offering
In May 1996, the Company completed an initial public offering of 1,150,000
units (the "Units"), each Unit consisting of one share of common stock and one
redeemable warrant ("Redeemable Warrant") at a price of $9.00 per Unit for gross
proceeds of $10,350,000. In connection with the offering, the Company issued
warrants to the Underwriters to purchase 100,000 shares of Common Stock (the
"Underwriter Warrants") for gross proceeds of $10. Net proceeds received by the
Company, after underwriting discounts and expenses of $1,231,897 and other
expenses of $821,938, amounted to $8,296,175. As of March 29, 1996, the Company
had incurred, and deferred as other assets, offering expenses of $338,372.
Accordingly, net proceeds during the six months ended September 27, 1996
amounted to $8,634,547.
8
<PAGE>
Two Redeemable Warrants entitle the holder thereof to purchase one share of
common stock at an exercise price of $11.00 per share. Unless the Redeemable
Warrants are redeemed, the Redeemable Warrants may be exercised at any time
beginning on May 10, 1996 and ending May 9, 1999, at which time the Redeemable
Warrants will expire. Beginning on February 10, 1997, the Redeemable Warrants
are redeemable by the Company at its option, as a whole and not in part, at $.05
per Redeemable Warrant on 30 days' prior written notice, provided that the
average closing bid price of the common stock equals or exceeds $12.00 per share
for 20 consecutive trading days ending within five days prior to the date of the
notice of redemption. The Redeemable Warrants will be entitled to the benefit of
adjustments in the exercise price and in the number of shares of common stock
deliverable upon the exercise thereof upon the occurrence of certain events,
including a stock dividend, stock split or similar reorganization.
The Underwriter Warrants are initially exercisable at a price of $10.80 per
share of common stock. The Underwriter Warrants contain anti-dilution provisions
providing for adjustments of the number of warrants and exercise price under
certain circumstances. The Underwriter Warrants grant to the holders thereof
certain rights of registration of the securities issuable upon exercise of the
Underwriter Warrants. The Underwriter Warrants may be exercised at any time
beginning on May 10, 1997 and ending May 9, 2001, at which time the Underwriter
Warrants will expire.
Common Stock Purchase Warrants
On May 23, 1995, the Company issued a warrant to one of its contract
manufacturers to purchase 40,000 shares of common stock, $.01 par value, at a
price of $4.00 per share in return for the extension of credit under the terms
of a manufacturing agreement between the Company and the contract manufacturer.
On June 17, 1996, the warrant was exercised and the Company issued 40,000 shares
of common stock for aggregate proceeds of $160,000.
Income (Loss) Per Common and Common Equivalent Share
Income (loss) per common and common equivalent share for the three months
and six months ended September 27, 1996 and September 29, 1995 is computed on
the basis of the weighted average number of common shares outstanding and
dilutive common equivalent shares outstanding during the period, except as
required pursuant to Accounting Principles Board Opinion No. 15, Earnings per
Share, all outstanding options and warrants during the three months and six
months ended September 27, 1996 have been included in the calculation in
accordance with the modified treasury stock method and except as required
pursuant to Securities and Exchange Commission Staff Accounting Bulletin
("SECSAB") Topic 4:D, shares of common stock underlying warrants issued and
options granted during the 12 months prior to the Company's May 10, 1996 initial
public offering (see Note 4) at prices below the public offering price have been
included in the calculation of weighted average of common and common equivalent
shares outstanding as if they were outstanding as of the beginning of the
periods.
9
<PAGE>
5. INCOME TAXES
There was no provision for income taxes for the three months and six months
ended September 29, 1995. The provision for income taxes charged to operations
for the three months and six months ended September 27, 1996 was as follows:
Three Months Six Months
Ended Ended
September 27, September 27,
1996 1996
--------- ---------
Current tax expense:
Federal $ 274,618 $ 565,566
State 41,150 84,790
--------- ---------
315,768 650,356
--------- ---------
Deferred tax benefit:
Federal (143,609) (323,528)
State (20,064) (45,199)
--------- ---------
(163,673) (368,727)
--------- ---------
152,095 281,629
Tax benefits of operating loss carryforwards -- (71,995)
Tax benefits applied to goodwill 75,159 234,822
--------- ---------
$ 227,254 $ 444,456
========= =========
The provision for income taxes differs from the amount of income taxes
determined by applying the applicable U.S. statutory federal income tax rate to
income (loss) before income taxes as a result of the following differences:
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
------------------------------- -------------------------------
September 27, September 29, September 27, September 29,
1996 1995 1996 1995
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Statutory U.S. tax rates $ 208,298 $ 80,275 $ 481,074 $ 1,852
State taxes, net of federal benefit 17,896 -- 44,172 --
Non-deductible expenses 14,003 25,721 28,935 51,442
Losses for which no tax benfit was
provided -- -- -- 52,702
Utilization of loss carryforwards -- (105,996) (71,995) (105,996)
Net deferred tax benefits (12,943) -- (37,730) --
--------- --------- --------- ---------
Effective tax rates $ 227,254 $ -- $ 444,456 $ --
========= ========= ========= =========
</TABLE>
10
<PAGE>
6. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information for the six months ended September 27,
1996 and September 29, 1995 consists of the following:
Six Months Ended
--------------------------------
September 27, September 29,
1996 1995
-------- --------
Interest paid $339,836 $456,533
Income taxes paid 294,044 --
Deferred offering expenses charged
against proceeds of initial public
offering 338,372 --
Realization of deferred tax assets
applied to goodwill 159,663 --
Other current assets acquired by
assumption of debt obligations -- 131,594
Write-off of property and
equipment against accounts
payable -- 1,600
Increase in goodwill from
distribution of escrow
consideration -- 329,709
In addition, during the six months ended September 27, 1996, the Company
applied $151,318 of deferred tax benefits to goodwill with respect to acquired
deferred tax assets as of March 29, 1996 as a result a reassessment of the
realizability thereof.
7. RESTRUCTURING CHARGES
During August 1996, the Company initiated a consolidation plan intended to
augment its on-going productivity and quality improvement programs. In
connection with this plan, the Company initiated the closure of one of its
manufacturing facilities, and recorded a restructuring charge of $62,500
consisting primarily of estimated severance obligations. The Company intends to
consolidate its service operations into its other manufacturing facility and to
lease a new facility to enable the consolidation of product assembly operations
and corporate headquarters by the end of fiscal 1997.
8. COMMITMENTS AND CONTINGENT LIABILITIES
Pursuant to the terms of a settlement agreement and mutual release dated
July 3, 1996, a suit filed against the Company by a former supplier to collect
approximately $400,000 of unpaid obligations was dismissed with prejudice.
Pursuant to the terms of the settlement agreement, the Company paid $180,000 and
agreed to pay an additional $112,500 in six equal monthly installments of
$18,750 commencing on August 15, 1996. As a result of the settlement agreement
the Company realized a gain of $105,146 representing the difference between
unpaid obligations recorded in the Company's accounts and aggregate settlement
payments set forth in the settlement agreement. The gain is reflected in the
Company's results of operations for the six months ended September 27, 1996.
11
<PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Forward Looking Statements
This report contains certain forward looking statements concerning the
Company's operations, economic performance and financial condition. Such
statements are subject to various risks and uncertainties. Actual results could
differ materially from those currently anticipated due to a number of factors,
including those identified herein.
Results of Operations
For the Three Months Ended September 27, 1996 Compared to the
Three Months Ended September 29, 1995
Overview. The Company's income before taxes for the three months ended
September 27, 1996 increased by $376,539, or 159%, to $612,643 as compared to
$236,104 for the three months ended September 29, 1995. During the three months
ended September 27, 1996, the Company recorded an income tax provision of
$227,254. No income tax provision was recorded during the three months ended
September 29, 1995. Net income for the three months ended September 27, 1996
increased by 63% to $385,389 versus $236,104 for the same period last year.
Primary earnings per share for the three months ended September 27, 1996
increased to $.08 per share based on 5,007,791 common and common equivalent
shares outstanding versus $.06 per share based on 3,805,625 common and common
equivalent shares outstanding for the three months ended September 29, 1995.
Sales. Sales increased by $2,324,038, or 30%, to $10,061,718 for the three
months ended September 27, 1996 (second quarter of fiscal 1997) from $7,737,680
for the three months ended September 29, 1995 (second quarter of fiscal 1996).
The increase in sales is primarily attributable to an increase in sales volume,
particularly sales that related to smart payphone products and components. Sales
of smart payphone products and components increased by approximately $2.1
million (43%), and accounted for approximately 69% of sales during the second
quarter of fiscal 1997 as compared to 63% of sales during the second quarter of
fiscal 1996. Refurbishment and repair services and related product sales for the
second quarter of fiscal 1997 increased by approximately $225,000 (8%) as
compared to the same period last year, and accounted for 29% of sales as
compared to 35% last year. Sales during the second quarter of fiscal 1997
include export sales of approximately $160,000 as compared to export sales of
approximately $127,000 during the second quarter of fiscal 1996.
A significant portion of the Company's sales during the second quarter of
fiscal 1997 were attributable to shipments pursuant to a sales agreement between
the Company and NYNEX Corp. ("NYNEX") executed in December 1995. During the
second quarter of fiscal 1996, a significant portion of the Company's sales were
attributable to shipments pursuant to a sales agreement between the Company and
Southwestern Bell Telephone Company ("SWB") executed in December 1994. See
"Liquidity and Capital Resources - Operating Trends and Uncertainties," below
for a discussion of the Company's dependence on significant customers and
contractual relationships.
Cost of Goods Sold. Cost of goods sold increased by $1,624,014, or 26%, to
$7,769,914 during the second quarter of fiscal 1997 as compared to $6,145,900
during the second quarter of fiscal 1996. The increase in cost of products sold
is primarily attributable to the 30% increase in sales during the second quarter
of fiscal 1997 as compared to the second quarter of fiscal 1996. Although
certain sales price reductions had a negative impact on product margins, the
increase in volume and variations in product mix had a favorable impact on
production costs as a percentage of sales. Overall, cost of goods sold as a
percentage of sales declined to 77% during the second quarter of fiscal 1997 as
compared to 79% of sales during second quarter of fiscal 1996.
12
<PAGE>
General and Administrative Expenses. General and administrative expenses
increased by $173,614, or 32%, to $717,871 (7% of sales) during the second
quarter of fiscal 1997 from $544,257 (7% of sales) during the second quarter of
fiscal 1996. The increase in general and administrative expenses is primarily
related to the increase in the volume of business, amortization of deferred
patent license fees with respect to a patent license acquired in September 1995,
an increase in accrued compensation pursuant to the terms of an employment
agreement between the Company and its president and accrued compensation with
respect to a bonus plan adopted by the Board of Directors during the second
quarter of fiscal 1997. Pursuant to the terms of the bonus plan, key employees
of the Company will receive additional compensation based on the annual
operating results of the Company in excess of a defined return on stockholders'
equity.
Marketing and Selling Expenses. Marketing and selling expenses decreased by
$128,298, or 40%, to $193,630 (2% of sales) during the second quarter of fiscal
1997 as compared to $321,928 (4% of sales) during the second quarter of fiscal
1996. The decrease is primarily attributable to a decrease in royalty expense
associated with sales of smart payphone products. The obligation to pay
royalties on sales of the Company's smart payphone products expired on June 30,
1996.
Engineering, Research and Development Expenses. Engineering, research and
development expenses increased by $389,915, or 147%, to $655,526 (7% of sales)
during the second quarter of fiscal 1997 as compared to $265,611 (3% of sales)
during the second quarter of fiscal 1996 due to an expansion of engineering
resources and product development activities. The Company began to expand its
engineering resources during the first quarter of fiscal 1997 in order to
facilitate smart product development activities and the implementation of
lower-cost manufacturing methodologies.
Restructuring Charges. During August 1996, the Company initiated a
consolidation plan intended to augment its on-going productivity and quality
improvement programs. In connection with this plan, the Company initiated the
closure of one of its manufacturing facilities, and recorded a restructuring
charge of $62,500 consisting primarily of estimated severance obligations. The
Company intends to consolidate its service operations into its other
manufacturing facility and to lease a new facility to enable the consolidation
of product assembly operations and corporate headquarters by the end of fiscal
1997. In order to assure continuity of supply, the Company has recently
out-sourced in-house printed circuit board assembly operations until the new
facility is established and commences assembly operations.
Interest Expense. Interest expense decreased to $63,047 during the second
quarter of fiscal 1997 as compared to $231,304 during the second quarter of
fiscal 1996 primarily due to the repayment of outstanding bank and stockholder
debt obligations during May 1996 from proceeds of the Company's initial public
offering. See "Liquidity and Capital Resources - Cash Flows From Financing
Activities," below.
Income Taxes. During the second quarter of fiscal 1997, the Company
recorded an income tax provision of $227,254, net of deferred tax benefits of
$88,514, on pre-tax income of $612,643. Benefits of acquired deferred tax assets
aggregating $75,159 were applied to goodwill during the three months ended
September 27, 1996. There was no income tax provision during second quarter of
fiscal 1996. Benefits of net operating loss carryforwards used to offset current
taxable income during the three months ended September 29, 1995 amounted to
$105,996.
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For the Six Months Ended September 27, 1996 Compared to the
Six Months Ended September 29, 1995
Overview. The Company's income before taxes for the six months ended
September 27, 1996 increased by $1,409,479, to $1,414,925 as compared to $5,446
for the six months ended September 29, 1995. During the six months ended
September 27, 1996, the Company recorded an income tax provision of $444,456. No
income tax provision was recorded during the six months ended September 29,
1995. Net income for the six months ended September 27, 1996 increased to
$970,469 versus $5,446 for the same period last year. Primary earnings per share
for the six months ended September 27, 1996 increased to $.21 per share based on
5,007,791 common and common equivalent shares outstanding versus $.00 per share
based on 3,805,625 common and common equivalent shares outstanding for the six
months ended September 29, 1995.
Sales. Sales increased by $8,048,389, or 57%, to $22,140,214 for the six
months ended September 27, 1996 (first six months of fiscal 1997) from
$14,091,825 for the six months ended September 29, 1995 (first six months of
fiscal 1996). As with the three month periods, the increase in sales is
primarily attributable to an increase in sales volume, particularly sales that
related to smart payphone products and components. Sales of smart payphone
products and components increased by approximately $7.6 million (94%), and
accounted for approximately 71% of sales during the first six months of fiscal
1997 as compared to 57% of sales during the first six months of fiscal 1996.
Refurbishment and repair services and related product sales for the first six
months of fiscal 1997 increased by approximately $517,000 (9%) as compared to
the same period last year, and accounted for 28% of sales as compared to 41%
last year. Sales during the first six months of fiscal 1997 include export sales
of approximately $160,000 as compared to export sales of approximately $256,000
during the first six months of fiscal 1996.
A significant portion of the Company's sales during the first six months of
fiscal 1997 were attributable to shipments pursuant to the aforementioned sales
agreement between the Company and NYNEX. During the first six months of fiscal
1996, a significant portion of the Company's sales were attributable to
shipments pursuant to the aforementioned sales agreement between the Company and
SWB. Sales volume during the first six months of fiscal 1996, however, was
adversely affected by a recall of smart products initiated by the Company as a
result of potential product failures from contamination introduced into the
manufacturing process by the Company's contract manufacturer. See "Liquidity and
Capital Resources - Operating Trends and Uncertainties," below for a discussion
of the Company's dependence on significant customers and contractual
relationships and for further information concerning the recall.
Cost of Goods Sold. Cost of goods sold increased by $6,169,336, or 54%, to
$17,610,363 during the first six months of fiscal 1997 as compared to
$11,441,027 during the first six months of fiscal 1996. The increase in cost of
products sold is primarily attributable to the 57% increase in sales during the
first six months of fiscal 1997 as compared to the first six months of fiscal
1996. Although certain sales price reductions had an adverse impact on product
margins, the increase in volume and variations in product mix had a favorable
impact on production costs as a percentage of sales. Overall, cost of goods sold
as a percentage of sales declined to 80% during the first six months of fiscal
1997 as compared to 81% of sales during first six months of fiscal 1996.
General and Administrative Expenses. General and administrative expenses
increased by $284,241, or 26%, to $1,362,856 (6% of sales) during the first six
months of fiscal 1997 from $1,078,615 (8% of sales) during the first six months
of fiscal 1996. The increase in general and administrative expenses is primarily
related to the increase in the volume of business, amortization of deferred
patent license fees with respect to a patent license acquired in September 1995,
an increase in accrued compensation pursuant to the aforementioned employment
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agreement between the Company and its president and accrued compensation under
to the bonus plan adopted during the three months ended September 27, 1997.
Marketing and Selling Expenses. Marketing and selling expenses decreased by
$31,544, or 5%, to $555,108 (3% of sales) during the first six months of fiscal
1997 as compared to $586,652 (4% of sales) during the first six months of fiscal
1996. The decrease is primarily attributable to a decrease in royalty expense
associated with sales of smart payphone products offset by commission
compensation accrued pursuant to a sales commission plan adopted during fiscal
1997.
Engineering, Research and Development Expenses. Engineering, research and
development expenses increased by $512,581, or 93%, to $1,064,621 (5% of sales)
during the first six months of fiscal 1997 as compared to $552,040 (4% of sales)
during the first six months of fiscal 1996 primarily due to an expansion of
engineering resources and product development activities. The Company began to
expand its engineering resources during the first quarter of fiscal 1997 in
order to facilitate smart product development activities and the implementation
of lower-cost manufacturing methodologies.
Litigation Settlement. Pursuant to the terms of a settlement agreement and
mutual release dated July 3, 1996, a suit filed against the Company by a former
supplier to collect approximately $400,000 of unpaid obligations was dismissed
with prejudice. As a result of the settlement agreement, the Company realized a
gain of $105,146 representing the difference between unpaid obligations recorded
in the Company's accounts and aggregate settlement payments set forth in the
settlement agreement.
Interest Expense. Interest expense decreased to $204,587 during the first
six months of fiscal 1997 as compared to $437,889 during the first six months of
fiscal 1996 primarily due to the repayment of outstanding bank and stockholder
debt obligations during May 1996 from proceeds of the Company's initial public
offering. See "Liquidity and Capital Resources - Cash Flows From Financing
Activities," below.
Income Taxes. During the first six months of fiscal 1997, the Company
recorded an income tax provision of $444,456, net of net operating loss
carryforwards and deferred tax benefits of $205,900, on pre-tax income of
$1,414,925. Benefits of acquired deferred tax assets aggregating $234,822,
including benefits of acquired net operating loss carryforwards of $38,360, were
applied to goodwill. There was no income tax provision during the six months
ended September 29, 1995. Benefits of net operating loss carryforwards used to
offset current taxable income during the first six months of fiscal 1996
amounted to $105,996.
Liquidity and Capital Resources
Initial Public Offering
During May 1996, the Company completed an initial public offering of
1,150,000 Units, each Unit consisting of one share of Common Stock and a
Redeemable Warrant, at a price of $9.00 per Unit for gross proceeds of
$10,350,000. In connection with the offering, the Company issued warrants to the
Underwriters to purchase 100,000 shares of Common Stock (the "Underwriter
Warrants") for gross proceeds of $10. Net proceeds received by the Company as of
September 27, 1996, after underwriting discounts and expenses of $1,231,897 and
other expenses of $821,938, aggregated $8,296,175. As of March 29, 1996, the
Company had incurred and deferred offering expenses of $338,372. Accordingly,
net proceeds from the Company's initial public offering during the six months
ended September 27, 1996 aggregated $8,634,547.
The net proceeds of the offering were initially used to repay then
outstanding indebtedness consisting of subordinated notes payable to
stockholders of $2.8 million and bank indebtedness aggregating $6,318,113 (see
"Cash Flows From Financing Activities," below). Indebtedness pursuant to the
Loan Agreement between the Company and its bank repaid with the net proceeds
consisted of a $2.2 million term note due November 30, 1997, $309,524
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outstanding under a $650,000 term note due November 30, 1997 and borrowings
under a revolving credit agreement of $3,808,589.
The Loan Agreement
The Loan Agreement between the Company and its bank provides financing to
the Company under a revolving credit agreement and term and installment notes of
up to $9 million. Pursuant to an October 31, 1994 amendment to the Loan
Agreement, $2.2 million of debt outstanding under the revolving credit agreement
was converted into a term note payable on November 30, 1997, the interest rate
on amounts borrowed under the terms of the Loan Agreement was reduced by ae% and
the term of the Loan Agreement was extended from May 31, 1995 to November 30,
1997. At March 29, 1996, the Company had outstanding indebtedness of $1,093,735
under the revolving credit agreement and $2,525,000 under term and installment
notes, including the $2.2 million term note due November 30, 1997. At March 29,
1996, the term and installment notes consisted of a term note with an
outstanding balance of $2.2 million and a term note with an outstanding balance
of $325,000. At September 27, 1996, the Company had outstanding indebtedness of
$1,795,377 under the revolving credit agreement after repayments from the net
proceeds of the initial public offering. As of September 27, 1996, outstanding
indebtedness under the Loan Agreement bears interest at a variable rate per
annum equal to 1.5% above a base rate quoted by Citibank, N.A. The interest rate
was reduced from 2% above a base rate quoted by Citibank, N.A. on March 1, 1996.
The base rate at September 27, 1996 and March 29, 1996 was 8.25% per annum.
Amounts borrowed under the Loan Agreement are secured by substantially all
assets of the Company, including accounts receivable, inventories and property
and equipment. The Loan Agreement expires on November 30, 1997, and is renewable
annually for one-year periods unless terminated by the bank upon an occurrence
of an event of default or by the Company upon at least 90 days notice.
The Loan Agreement contains conditions and covenants that prevent or
restrict the Company from engaging in certain transactions without the consent
of the bank, including merging or consolidating, payment of subordinated
stockholder debt obligations, declaration or payment of dividends, and
disposition of assets, among others. Additionally, the Loan Agreement requires
the Company to comply with specific financial covenants, including covenants
with respect to cash flow, working capital and net worth. Noncompliance with any
of these conditions and covenants or the occurrence of an event of default, if
not waived or corrected, could accelerate the maturity of the borrowings
outstanding under the Loan Agreement. Although the Company is in compliance with
the covenants set forth in the Loan Agreement as of September 27, 1996, there is
no assurance that the Company will be able to remain in compliance with such
covenants in the future.
The Company used the net proceeds of its initial public offering to repay
outstanding indebtedness under the Loan Agreement in order to reduce its
interest expense. The Company intends to use the financing available under the
Loan Agreement to finance its on-going working capital needs. If an event of
default under the existing working capital facility were to occur, however, the
Company's ability in this regard could be curtailed. In such event, the Company
would seek alternative financing sources.
Cash Flows From Financing Activities
Cash provided by financing activities during the six months ended September
27, 1997 aggregated $4,136,748, including the net proceeds from the initial
public offering of $8,634,547, as compared to $554,061 during the six months
ended September 29, 1995.
Net proceeds under the Company's revolving credit agreement during the six
months ended September 27, 1996 amounted to $701,642 as compared to net proceeds
of $647,952 during the six months ended September 29, 1995. Net proceeds under
the revolving credit agreement during the six months ended September 27, 1996
reflect the repayment of $3,808,589 of indebtedness from the proceeds of the
Company's initial pubic offering. Exclusive of such repayment, the net proceeds
under the revolving credit agreement during the six months ended September 27,
1997 aggregated $4,510,231. The net proceeds under the revolving credit
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agreement were used to fund the Company's net cash requirements during the six
months ended September 27, 1997 and September 29, 1995.
Principal payments on long-term debt and capital lease obligations during
the six months ended September 27, 1996 aggregated $2,594,460, including
repayment of the $2.2 million term note due November 30, 1997 and the repayment
of $309,524 outstanding under the $650,000 term note due November 30, 1997 from
the proceeds of the Company's initial public offering. Principal payments on
long-term debt and capital lease obligations during the six months ended
September 27, 1996, excluding the repayments of term and installment note
indebtedness from the proceeds of the offering, amounted to $84,936, as compared
to $496,303 during the six months ended September 29, 1995. The decrease in
principal payments (exclusive of repayments made from proceeds of the offering)
for the six months ended September 27, 1996 as compared to the corresponding
period last year is attributable to debt maturing during fiscal 1997.
Pursuant to an October 31, 1994 Investment Agreement, the Company borrowed
$2.8 million from its stockholders, and issued 10% interest bearing subordinated
promissory notes due November 1, 1999. These subordinated promissory notes were
repaid during the six months ended September 27, 1996 from the proceeds of the
Company's initial public offering.
The Company has also established a cash management program with its bank
pursuant to which the Company funds drafts as they clear the bank. Accordingly,
the Company maintains bank overdrafts representing outstanding drafts and
utilizes the cash management account as a source of funding. Bank overdrafts
vary according to many factors, including the volume of business, and the timing
of purchases and disbursements. During the six months ended September 27, 1996,
the Company's bank overdrafts increased by $31,269 as compared to an increase of
$402,412 during the six months ended September 29, 1995.
In June 1996, the Company issued 40,000 shares of common stock for
aggregate proceeds of $160,000 upon the exercise of outstanding common stock
purchase warrants issued in May 1995. See "Capital Commitments and Liquidity,"
below. In September 1996, the Company issued 3,750 shares of common stock upon
the exercise of incentive stock options at an aggregate exercise price of
$3,750.
Cash Flows From Operating Activities
Six Months Ended September 27, 1996. Cash used to fund operating activities
during the six months ended September 27, 1996 amounted to $3,801,658. During
the six months ended September 27, 1996, the Company's operations generated
$1,874,565 in cash, after adjustments related to non-cash charges and credits of
$904,096. In addition, a decrease in accounts receivable and prepaid expenses
and other assets provided cash of $855,777 and $17,855, respectively, and an
increase in income taxes payable provided cash of $284,317 during the six months
ended September 27, 1996. However, net cash used to fund increases in
inventories of $5,189,527 and decreases in accounts payable of $612,199,
deferred revenue of $541,245 and accrued liabilities of $491,993 aggregated
$6,834,964 during the six months ended September 27, 1996. The decline in
accounts receivable was primarily attributable to the rescheduling of shipments
in accordance with customer requirements and installation schedules. The
increase in inventories was primarily attributable to the aforementioned
rescheduling of shipments and the final production run of printed circuit board
assemblies for one of the Company's smart products to meet anticipated sales
requirements until the planned release of the Company's next generation smart
product series. The decrease in accounts payable is related to the Company's
efforts to reduce the increase in inventories during the latter part of the
period. The Company satisfied its delivery requirements with respect to revenues
deferred at the end of fiscal 1996 and deferred revenue decreased accordingly.
The decrease in accrued expenses is primarily related to the expiration of
royalty agreements and the payment of remaining royalties during the six months
ended September 27, 1996.
Six Months Ended September 29, 1995. Cash used to fund operating activities
during the six months ended September 29, 1995 amounted to $657,605. During the
six months ended September 29, 1995, the Company's operations generated $650,019
in cash, after adjustments related to non-cash charges of $644,573. In addition,
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cash provided by an increase in accounts payable of $720,481 and a decrease in
prepaid expenses and other assets of $22,229 aggregated $742,710 during the
period. However, cash used to fund increases in accounts receivable and
inventories amounted to $1,433,290 and $452,803 respectively, and cash used to
fund decreases in accrued liabilities and restructuring charges aggregated
$163,665. The increases in accounts payable, accounts receivable and inventories
during the six months ended September 29, 1995 were primarily related to the
increase in the volume of business. The decrease in accrued liabilities and
accrued restructuring charges was primarily related to the payment of accrued
interest on shareholder notes and the settlement of a lease obligation included
in formerly established restructuring reserves, respectively.
Cash Flows From Investing Activities
Cash used to fund investing activities during the six months ended
September 27, 1996 amounted to $197,512 as compared to $132,206 during six
months ended September 29, 1995. During the six months ended September 27, 1996,
the Company expanded its investment in manufacturing and automated test
equipment located at its contract manufacturer, began to invest in equipment and
hardware required to manufacture its next generation smart product series, and
began a program to upgrade its in-house testing capability. During the
corresponding period last year, the Company's investing activities were
primarily related to the introduction a new smart payphone product. The Company
expects that its capital expenditures over the next several quarters will
continue to grow as the Company invests in manufacturing and test equipment
required to improve its in-house prototype and manufacturing capabilities and
moves forward to select and begin the implementation of new management
information systems (see "Capital Commitments and Liquidity," below).
Capital Commitments and Liquidity
The Company has not entered into any significant commitments for the
purchase of capital assets. However, the Company intends to purchase and install
information systems and capital equipment, including printed circuit board
assembly equipment and other manufacturing equipment, to advance its prototype
manufacturing and product testing capabilities during the eighteen months
following the date of the Company's initial public offering. In addition, the
Company intends to expand its manufacturing capabilities through the purchase of
capital equipment in the future as required to meet the needs of its business.
The Company expects to expend approximately $800,000 to fund anticipated capital
expenditures during the eighteen month period following the initial public
offering. However, there can be no assurance that capital expenditures will be
made as planned or that additional capital expenditures will not be required.
The Company believes, based on its current plans and assumptions relating to its
operations, that its sources of capital, including capital available under its
revolving credit line and cash flow from operations will be adequate to satisfy
its anticipated cash needs, including anticipated capital expenditures, for at
least the next year. However, in the event that the Company's plans or the basis
for its assumptions change or prove to be inaccurate, or cash flow and sources
of capital prove to be insufficient to provide for the Company's cash
requirements (due to unanticipated expenses, loss of sales revenues, problems,
operating difficulties or otherwise), the Company would be required to seek
additional financing. In such an event, there can be no assurance that
additional financing will be available to the Company on commercially reasonable
terms, or at all.
Extension of credit to customers and inventory purchases represent the
principal working capital requirements of the Company, and significant increases
in accounts receivable and inventory balances could have an adverse effect on
the Company's liquidity. The Company's accounts receivable, less allowances for
doubtful accounts, at September 27, 1996 and March 29, 1996 amounted to
$2,954,596 and $3,866,372, respectively. Accounts receivable at September 27,
1996 and March 29, 1996 consists primarily of amounts due from the RBOCs. The
Company's inventories, less allowances for potential losses due to obsolescence
and excess quantities amounted to $13,635,212 and $8,658,669 at September 27,
1996 and March 29, 1996, respectively. The level of inventory maintained by the
Company is dependent on a number of factors, including delivery requirements of
customers, availability and lead-time of components and the ability of the
Company to estimate and plan the volume of its business. The Company markets a
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wide range of services and products and the requirements of its customers vary
significantly from period to period. Accordingly, inventory balances may vary
significantly.
In October 1994, the Company entered into a contract manufacturing
agreement that provides for the production of certain smart payphone processors.
Pursuant to the terms of the manufacturing agreement, the Company committed to
purchase $12.2 million of product over an eighteen-month period beginning in
December 1994. In addition, in November 1994, the Company entered into a dealer
agreement that commits the Company to purchase approximately $3.5 million of
electronic lock devices over a two-year period. Purchases under the terms of
these agreements fluctuate based on delivery requirements established by the
Company. The Company initially scheduled purchases pursuant to these agreements
based on anticipated quantities required to meet its sales commitments. As of
September 27, 1996, the Company had acquired the majority of committed purchase
volume pursuant to these purchase agreements. However, as a result of changes in
delivery requirements of one of the Company's customers, the Company's
inventories related to such agreements increased by approximately $2 million
during the six months ended September 27, 1996. Also, the Company's inventories
of printed circuit board assemblies related to another smart payphone product
increased by approximately $3 million during the six months ended September 27,
1996 as a result of the final production run to meet anticipated sales
requirements until the planned release of TSG's next generation smart product
series.
In December 1994, the Company sold the rights to certain product software
for an aggregate purchase price of $500,000. The Company received back an
exclusive irrevocable perpetual right to sublicense the software in connection
with the sale of related products. In return, the Company agreed to pay
royalties on sales of licensed products to other customers. Such royalties would
be payable commencing if, and only if, laws, regulations or judicial actions
occur which would permit the purchaser of the software to receive such royalty
payments. The Company is obligated to repay, three years from the date of sale,
a portion of the purchase price up to a maximum amount of $375,000, which is
reflected as deferred revenue in the Company's consolidated financial statements
at September 27, 1996 and March 29, 1996. The actual amount of any repayment is
dependent upon the amount of aggregate royalties paid pursuant to the license
agreement during such three-year period. The amount of repayment will equal: (i)
$375,000 if aggregate royalties paid amount to less than $125,000; (ii) $250,000
if aggregate royalties paid are greater than $125,000 but less than $250,000; or
(iii) $125,000 if aggregate royalties paid are greater than $250,000 but less
than $375,000. If aggregate royalties paid during the first three years of the
agreement exceed $375,000, the Company is not required to repay any portion of
the purchase price. As of September 27, 1996, the Company is not obligated to
pay and has not paid any royalties under the agreement.
Operating Trends and Uncertainties
Dependence on Customers and Contractual Relationships
The Company markets its payphone products and services predominately to the
Regional Bell Operating Companies ("RBOCs"). In fiscal years 1994, 1995 and
1996, sales to RBOCs accounting for greater than 10% of the Company's sales
aggregated 73%, 72% and 88%, respectively, of the Company's sales revenues. The
Company's significant customers during the past three years have included
Ameritech Services, Inc., Bell Atlantic Corp. ("Bell Atlantic"), BellSouth
Telecommunications, Inc., Southwestern Bell Telephone Company ("SWB") and NYNEX
Corp. ("NYNEX"). During the three months ended September 27, 1996, Ameritech
Services, Inc., Bell Atlantic, NYNEX and SWB accounted for approximately $1.0
million, $1.3 million, $6.9 million and $.4 million, respectively, of the
Company's sales. During the three months ended September 29, 1995, Bell
Atlantic, NYNEX and SWB accounted for approximately $1.4 million, $.6 million
and $4.5 million, respectively, of the Company's sales. During the six months
ended September 27, 1996, Ameritech Services, Inc., Bell Atlantic, NYNEX and SWB
accounted for approximately $2.2 million, $2.7 million, $15.0 million and $1.6
million, respectively, of the Company's sales. During the six months ended
September 29, 1995, Bell Atlantic, NYNEX and SWB accounted for approximately
$2.9 million, $1.2 million and $7.6 million, respectively, of the Company's
sales.
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The Company anticipates that it will continue to derive most of its
revenues from such customers, and other regional telephone companies, for the
foreseeable future. The loss of any one of such RBOC customers or a significant
reduction in sales volume or sales prices to such RBOCs would have a material
adverse effect on the Company's business. Recently, two mergers between Pacific
Telesis Inc. and SBC Communications, Inc. (the parent of SWB), and between Bell
Atlantic and NYNEX were announced. The Company cannot predict the impact that
such mergers or other future mergers will or may have on the Company's business.
The Company competes for and enters into non-exclusive supply contracts to
provide products, components and services to the RBOCs. The Company has entered
into sales agreements to provide smart products to Ameritech Services, Inc. and
U.S. West. The Company has entered into sales agreements to provide payphone
components to Ameritech Services, Inc., BellSouth Telecommunications, Inc., Bell
Atlantic, NYNEX and SWB. The Company has entered into sales agreements to
provide repair, refurbishment and conversion services to Ameritech Services,
Inc., Bell Atlantic, NYNEX and SWB. These agreements have terms ranging from two
to three years, are renewable at the option of and subject to the procurement
process of the particular RBOC, contain fixed sales prices for the Company's
products and services with limited provisions for cost increases and expire at
various dates from July 1996 to March 1999. These sales agreements are
frameworks for dealing on open account and do not specify or commit the
Company's customers to purchase a specific volume of products or services. If
orders are made, however, the Company has agreed to fill such orders in
accordance with the customer's contract specifications. The agreements are
generally subject to termination at the option of the customer upon 30 days
notice to the Company, or if the Company defaults under any material provision
of the agreements, including provisions with respect to performance. In
addition, as further described below, the Company has entered into sales
agreements to provide smart products to NYNEX and SWB. The terms of these sales
agreements (the "firm commitment sales agreements"), however, include provisions
for the customers to purchase specific quantities of smart products and other
components from the Company at specified prices, subject to the cancellation
provisions thereof.
The Company's prospects for continued profitability are largely dependent
upon the RBOCs upgrading the technological capabilities of their installed base
of payphones, and utilizing the Company's products and services for such upgrade
conversion programs. To date, the Company believes that one of the RBOCs has
completed a technological upgrade program for its installed base of payphones
and that two of the RBOCs have commenced such a program. The two RBOCs that have
commenced upgrade programs, and which are significant customers of the Company,
have entered into sales agreements with the Company as described below.
In December 1994, the Company entered into a sales agreement with SWB
pursuant to which the Company agreed to supply and SWB agreed to purchase $21.3
million of smart processors and other components, including electronic locks,
over a three-year period at specified prices. The agreement also includes a
"most favored customer" clause pursuant to which the Company has agreed to
provide price and other terms at least as favorable as those extended by the
Company to other customers for the products covered by the agreement. The
agreement contains certain covenants and conditions relating to product quality
and delivery requirements, among others. The agreement provides for penalties
and damages in the event that the Company is unable to comply with certain
performance criteria. Upon a default by the Company with respect to such
covenants and conditions, SWB has the right to cancel the agreement or reduce
its purchase commitment, provided such default is not cured within a 20-day
notice period. In addition, SWB may in any event terminate the agreement upon at
least 30 days notice. However, upon such a termination, SWB has agreed to
purchase all finished goods then held by the Company and to pay contractor and
supplier cancellation and restocking charges, if any, plus a nominal profit
percentage above the cost of such materials. Because SWB has the right to
terminate the contract on 30 days notice as described above, there can be no
assurance that the Company will ultimately sell $21.3 million of smart
processors and other components pursuant to such contract. As of September 27,
1996, the Company estimates that the customer has acquired in excess of 65% of
committed volume under such sales agreement. However, as a result of changes in
SWB's delivery requirements, the Company does not anticipate shipping the
remaining volume pursuant to the terms of the agreement during the remainder of
the 1996 calendar year.
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In December 1995, the Company entered into an amendment to a sales
agreement with NYNEX pursuant to which the Company agreed to supply and NYNEX
agreed to purchase approximately $12 million of smart products and other
components over a eight-month period at specified prices. The agreement also
includes a "most favored customer" clause pursuant to which the Company has
agreed to provide price and other terms at least as favorable as those extended
by the Company to other customers for the products covered by the agreement. The
agreement contains certain covenants and conditions relating to product quality
and delivery requirements, among others. Upon a default by the Company with
respect to such covenants and conditions, NYNEX has the right to cancel the
contract, provided such default is not cured within a 14-day notice period.
Either party may terminate the agreement upon default by the other party of any
material provision of the agreement provided such default is not cured within a
10-day notice period. In addition, NYNEX has the right to cancel prior to
shipment any and all orders under the agreement and, in such event, would be
liable to the Company only for the cost of goods not otherwise usable or salable
by the Company. Because NYNEX has the right to terminate orders under the
contract as described above, there can be no assurance that the Company will
ultimately sell the $12 million of products under such contract. However, as of
September 27, 1996, the Company has satisfied the majority of its sales
commitment pursuant to the contract amendment, is continuing to supply products
under the terms of the agreement under modified delivery schedules, and is
competing for another long-term smart product contract award from NYNEX.
The termination of these or any of the Company's sales agreements would
have a material adverse effect on the Company's business. Further, any
assessment of damages under the Company's sales contracts could have a further
material adverse effect on the Company's operating results and liquidity. In
April 1995, the Company initiated a recall of products as a result of potential
products failures due to contamination introduced into the manufacturing process
by the Company's contract manufacturer. Although the Company's contract
manufacturer was responsible for the repair or replacement of the recalled
product, the Company incurred liquidated damages under the terms of the sales
agreement with its customer in the amount of $200,000. The damages were paid by
an $8.00 price reduction over the next 25,000 units shipped after July 1, 1995.
This liability was recorded in the Company's consolidated financial statements
at March 31, 1995. Also, the Company agreed to extend its warranty on up to
5,000 units shipped under the terms of the sales agreement through December 31,
1998. However, the Company does not anticipate that it will incur significant
warranty costs as a result of the extended warranty.
The Company's prospects and the ability of the Company to maintain a
profitable level of operations are dependent upon its ability to secure contract
awards from the RBOCs. In addition, the Company's prospects for growth are
dependent upon market acceptance and success of its smart products, as well as
development of other smart products containing additional advanced features. If
the Company is unable to attract the interest of the RBOCs to deploy the
Company's smart products, the Company's sales revenues, business and prospects
for growth would be adversely affected. Further, the Company's ability to
maintain and/or increase its sales is dependent upon its ability to compete for
and maintain satisfactory relationships with the RBOCs, particularly those RBOCs
presently representing significant customers of the Company. Prior to a
restructuring instituted in 1994, the Company experienced difficulties with a
first generation smart payphone product, which difficulties subsequently were
remedied. Such difficulties, however, resulted in the termination of a contract
for such product with one of the Company's then significant RBOC customers.
There can be no assurances that similar difficulties will not occur in the
future.
21
<PAGE>
Product Sales Prices
The Company's agreements with its contract manufacturers generally provide
that the Company will bear certain cost increases incurred by the manufacturer.
Accordingly, the Company's manufacturing costs may fluctuate based on costs
incurred by its contract manufacturers and such fluctuations could have a
material and adverse impact on earnings. The Company's sales agreements with
customers generally have fixed product prices with limited price escalation
provisions. Consequently, there is a risk that the Company may not be able to
pass on price increases to its customers. In the event the Company's costs
increase or orders are lost due to price increases, the Company's profitability
would be adversely affected. The Company encounters substantial competition with
respect to smart payphone contract awards by the RBOCs. Competition is beginning
to result in price reductions, which will result in reduced gross profit margins
unless the Company is able to achieve reductions in product costs.
Seasonality
The Company's sales are generally stronger during periods when weather does
not interfere with the maintenance and installation of payphone equipment by the
Company's customers, and may be adversely impacted near the end of the calendar
year by the budget short falls of customers. However, the Company may also
receive large year-end orders from its customers for shipment in December
depending upon their budget positions. In the event the Company does not receive
any significant end of year orders for its smart payphone products, its third
quarter sales may decline significantly in relation to other quarters.
Telecommunications Act of 1996
On February 8, 1996, the President signed into law the Telecommunications
Act of 1996 (the "Telecommunications Act"), the most comprehensive reform of
communications law since the enactment of the Communications Act of 1934. The
Telecommunications Act eliminates long-standing legal barriers separating local
exchange carriers, long distance carriers, and cable television companies and
preempts conflicting state laws in an effort to foster greater competition in
all telecommunications market sectors, improve the quality of services and lower
prices.
The Telecommunications Act expressly supersedes the consent decree which
led to the AT&T Divestiture, including the line-of-business restrictions that
prohibited the RBOCs from providing inter-exchange services and from
manufacturing telecommunications equipment. The RBOCs are now permitted to
provide inter-exchange service outside their local service areas and to seek
approval from the FCC to provide inter-exchange service within their local
service areas based upon a showing that they have opened their local exchange
markets to competition.
The Company believes that as a result of the reform legislation, the public
communications industry will undergo fundamental changes, many of which may
affect the Company's business. The legislation is likely to increase the number
of providers of telecommunications services, including perhaps providers of
payphone services. This increase in the number of providers is likely to
stimulate demand for new payphone equipment. In such event, the Company believes
that existing payphone providers, including the RBOCs, could seek to enhance
their technology base in order to compete more effectively with each other and
with new entrants. In addition, as the local exchange and intrastate long
distance markets are opened to competition, inter-exchange carriers seeking to
serve these markets may deploy greater numbers of payphones to capture local and
intrastate traffic.
In addition, as a result of the Telecommunications Act of 1996, the RBOCs
will be permitted to manufacture and provide telecommunications equipment and to
manufacture customer premises equipment when certain competitive conditions have
been met. It is possible that one or more RBOCs will decide to manufacture
payphone products, which would increase the competition faced by the Company and
could decrease demand for the Company's products by such RBOCs. Notwithstanding,
the Company believes that deregulation generally will benefit the Company.
22
<PAGE>
However, there can be no assurance that the Company will benefit from
deregulation or that it will not be adversely affected by deregulation.
On September 20, 1996, the FCC released its order adopting regulations to
implement the section of the Telecommunications Act which mandated fair
compensation for all payphone providers. The order addressed compensation for
non-coin calls, local coin calling rates, removal of subsidies and
discrimination favoring LEC payphones and authorization of RBOCs and other
providers to select service providers, among other matters. The Company
believes, but cannot assure, that the order will have a significant favorable
impact on the revenues of the payphone industry and will further stimulate
deployment of new payphone equipment by providers, including the RBOCs, and the
technological upgrade of the installed base of payphones operated by the RBOCs.
Sources of Supply and Dependence on Contract Manufacturers
The Company generally assembles its smart payphone products from assemblies
produced by certain manufacturers under contractual arrangements. To the extent
that such manufacturers encounter difficulties in their production processes
that delay shipment to the Company or that affect the quality of items supplied
to the Company, the Company's ability to perform its sales agreements or
otherwise to meet supply schedules with its customers can be adversely affected.
In the event that contract manufacturers delay shipments or supply defective
materials to the Company, and such delays or defects are material, the Company's
customer relations could deteriorate and its sales and operating results could
be materially and adversely affected.
The majority of the Company's products in terms of revenues contain
components or assemblies that are purchased from single sources. The Company
believes that there are alternative sources of supply for most of the components
and assemblies currently purchased from single sources. Some of the components
and assemblies used by the Company for which there are not immediately available
alternative sources of supply are provided to the Company under standard
purchase arrangements. If a shortage or termination of the supply of any one or
more of such components or assemblies were to occur, however, the Company's
business could be materially and adversely affected. In such event, the Company
would have to incur the costs associated with redesigning its products to
include available components or assemblies or otherwise obtain adequate
substitutes, which costs could be material. Also, any delays with respect to
redesigning products or obtaining substitute components would materially
adversely affect the Company's business.
Disputes
In October 1994, a contract manufacturer that delivered allegedly defective
first generation smart products to the Company discontinued operations prior to
the scheduled contract termination date. In April 1995, the contract
manufacturer formally terminated the Company's manufacturing contract as of the
scheduled termination date. Pursuant to the terms of the manufacturing contract,
the Company was committed to acquire the manufacturer's inventories related to
the Company's products. The Company has not acquired products or inventory from
the manufacturer since October 1994, and has not paid certain obligations that
were recorded as of the date the manufacturer ceased operations. The contract
manufacturer has claimed that TSG is obligated to (i) purchase inventories
approximating $l million, (ii) pay outstanding payable obligations of
approximately $265,000, and (iii) pay lost profits of the contract manufacturer
of approximately $916,000 related to the Company's minimum contract purchase
commitment. The Company has claimed that the contract manufacturer supplied
defective product, breached the agreement by discontinuing operations prior to
the scheduled termination date of the contract and that the delivery of
defective product resulted in the termination of a significant smart product
sales agreement and the loss of significant business and profits by the Company.
The Company does not believe, but cannot assure, that the contract manufacturer
will pursue its claims against the Company, nor does the Company intend to
pursue its claims against the contract manufacturer unless the manufacturer
commences an action against the Company. Should the contract manufacturer pursue
its claims against the Company, the Company intends to defend and pursue its
positions vigorously. However, there is no assurance that the outcome of any
action will not have a material adverse effect on the Company's financial
position or results of operations.
23
<PAGE>
Net Operating Loss Carryforwards
As of September 27, 1996, the Company had net operating loss carryforwards
for income tax purposes of approximately $15 million to offset future taxable
income. Under Section 382 of the Internal Revenue Code of 1986, as amended, the
utilization of net operating loss carryforwards is limited after an ownership
change, as defined in such Section 382, to an annual amount equal to the value
of the loss corporation's outstanding stock immediately before the date of the
ownership change multiplied by the federal long-term tax-exempt rate in effect
during the month the ownership change occurred. Such an ownership change
occurred on October 31, 1994 and could occur in the future. As a result, the
Company will be subject to an annual limitation on the use of its net operating
losses of approximately $210,000. Such limitation would have the effect of
increasing the Company's tax liability and reducing net income and available
cash resources of the Company if the taxable income during a year exceeded the
allowable loss carried forward to that year. In addition, because of such
limitations, the Company will be unable to use a significant portion of its net
operating loss carryforwards.
24
<PAGE>
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings
The Company has no pending material litigation.
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits
The following exhibits are filed herewith as a part of this Report.
Exhibit
No. Description of Exhibit
------- ----------------------
11. Statement re computation of per share earnings
27. Financial Data Schedule (EDGAR Filing only)
(b) Reports of Form 8-K
No reports on Form 8-K were filed during the quarter for which this
report is filed.
25
<PAGE>
SIGNATURES
Pursuant to the requirements 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.
TECHNOLOGY SERVICE GROUP, INC.
(Registrant)
Date: October 31 , 1996 By: /s/ Vincent C. Bisceglia
-----------------------------
Vincent C. Bisceglia
President & Chief Executive Officer
By: /s/ William H. Thompson
-----------------------------
William H. Thompson
Vice President of Finance
& Chief Financial Officer
26
<PAGE>
EXHIBIT INDEX
Exhibit No. Description of Exhibit At Page
- ----------- ---------------------- -------
11. Statement re computation of per share earnings 28
27. Financial Data Schedule (EDGAR filing only) 29
27
EXHIBIT 11
STATEMENT RE COMPUTATION OF EARNINGS PER SHARE
<TABLE>
<CAPTION>
Three Three Six Six
Months Months Months Months
Ended Ended Ended Ended
September 27, September 29, September 27, September 29,
1996 (1) 1995 (1) 1996 (1) 1995 (1)
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Weighted average number of common and
common equivalent shares outstanding:
Weighted average number of shares of
common stock outstanding during the
period 4,690,041 3,500,000 4,398,757 3,500,000
Incremental shares assumed to be
outstanding related to common stock
options granted and outstanding,
excluding options granted within twelve
months of initial public offering 497,500 345,750 432,749 345,750
Incremental shares assumed to be
outstanding related to common
stock options granted within
twelve months of initial public
offering 84,000 5,000 84,000 5,000
Incremental shares assumed to be
outstanding related to common stock
warrants issued and outstanding 675,000 40,000 532,886 40,000
Shares of common stock assumed to be
purchased upon exercise of outstanding
options and warrants (2) (938,750) (85,125) (721,583) (85,125)
----------- ----------- ----------- -----------
Weighted average number of common
and common equivalent shares
outstanding - Primary earnings per share 5,007,791 3,805,625 4,726,809 3,805,625
Adjustment of number of shares assumed to
be purchased upon exercise of options and
warrants based on the closing market price -- -- -- --
Weighted average number of common
and common equivalent shares outstanding -
----------- ----------- ----------- -----------
Earnings per share assuming full dilution 5,007,791 3,805,625 4,726,809 3,805,625
=========== =========== =========== ===========
Net income (loss) $ 385,389 $ 236,104 $ 970,469 $ 5,446
Adjustment of interest expense, net of tax
effect, related to assumed repayment of
debt obligations due to 20% limitation on
purchase of shares upon exercise of
outstanding options and warrants 4,392 -- -- --
----------- ----------- ----------- -----------
Net income (loss) as adjusted $ 389,781 $ 236,104 $ 970,469 $ 5,446
=========== =========== =========== ===========
Net income (loss) per share:
Primary $ 0.08 $ 0.06 $ 0.21 $ 0.00
=========== =========== =========== ===========
Assuming full dilution $ 0.08 $ 0.06 $ 0.21 $ 0.00
=========== =========== =========== ===========
</TABLE>
(1) Computations do not reflect exercise of outstanding options and warrants if
the effect thereof is anti-dilutive except as required by Accounting
Principles Board Opinion No. 15 (APB #15) under the modified treasury stock
method, and except as required by Securities and Exchange Commission
Accounting Bulletin Topic 4D, stock options granted during the twelve
months prior to the Company's initial public offering at prices below the
public offering price have been included in the calculation of weighted
average shares of common stock as if they were outstanding as of the
beginning of the periods presented.
(2) Shares of common stock assumed to be purchased with proceeds upon exercise
of outstanding options and warrants is based on the average market price of
the Company's common stock during the period and is limited to 20% of the
number of common shares outstanding at the end of the period, if applicable
in accordance with APB #15.
28
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
COMPANY'S FINANCIAL STATEMENTS FOR THE SIX MONTHS ENDED SEPTEMBER 27, 1996 AND
IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 6-mos
<FISCAL-YEAR-END> MAR-28-1997
<PERIOD-END> SEP-27-1996
<CASH> 157,365
<SECURITIES> 0
<RECEIVABLES> 3,227,089
<ALLOWANCES> (272,493)
<INVENTORY> 13,635,212
<CURRENT-ASSETS> 17,300,105
<PP&E> 3,468,291
<DEPRECIATION> (1,513,207)
<TOTAL-ASSETS> 23,176,248
<CURRENT-LIABILITIES> 8,878,987
<BONDS> 890,666
0
0
<COMMON> 46,938
<OTHER-SE> 12,981,459
<TOTAL-LIABILITY-AND-EQUITY> 23,176,248
<SALES> 22,140,214
<TOTAL-REVENUES> 22,140,214
<CGS> 17,610,363
<TOTAL-COSTS> 17,610,363
<OTHER-EXPENSES> 1,064,621
<LOSS-PROVISION> 55,999
<INTEREST-EXPENSE> 204,587
<INCOME-PRETAX> 1,414,925
<INCOME-TAX> 444,456
<INCOME-CONTINUING> 970,469
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 970,469
<EPS-PRIMARY> .21
<EPS-DILUTED> .21
</TABLE>
