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 ENDED September 30, 1997 .
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.
FOR THE TRANSITION PERIOD FROM TO .
Commission file number 0-28892
XLConnect Solutions, Inc.
-------------------------
(Exact name of registrant as specified in its charter)
Pennsylvania 23-2832796
------------------------------- ------------------
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
411 Eagleview Boulevard, Exton, PA 19341
------------------------------------------
(Address of principal executive offices) (Zip Code)
(610) 458-5500
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(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes __X__ No ____
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date: 16,655,000 shares of
Common Stock, par value $0.01 per share were outstanding on November 13,
1997.
<PAGE>
<PAGE>
XLConnect Solutions, Inc. and Subsidiaries
INDEX
Page No.
--------
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets as of September 30, 1997
and December 31, 1996 3
Consolidated Statements of Income for the Three and Nine
Months Ended September 30, 1997 and 1996 4
Consolidated Statements of Cash Flows for the Nine
Months Ended September 30, 1997 and 1996 5
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports Filed on Form 8-K 16
SIGNATURES 18
<PAGE> <PAGE>
<TABLE> <CAPTION>
PART I. Financial Information
Item 1. Consolidated Statements
XLConnect Solutions, Inc. and Subsidiaries
Consolidated Balance Sheets
(In thousands, except share-related data)
September 30, December 31,
1997 1996
(unaudited)
------------ ------------
ASSETS
Current assets:
<S> <C> <C> <C>
Cash and cash equivalents $ 23,749 $ 3,467
Trade accounts receivable, less allowance of $952 at
September 30, 1997 and $1,072 at December 31, 1996 27,769 23,063
Deferred tax asset 1,530 1,225
Prepayments and other current assets 1,681 1,155
----------- -----------
Total current assets 54,729 28,910
----------- -----------
Property and equipment, net of accumulated depreciation 5,855 4,985
Intangible assets, net of accumulated amortization 24,453 27,006
Other long-term assets 1,526 766
----------- -----------
Total assets $ 86,563 $ 61,667
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt $ 21 $ 67
Accounts payable 2,588 3,144
Accrued expenses 8,937 4,464
Deferred income and other 990 1,449
Due to Parent 12,717 257
----------- -----------
Total current liabilities 25,253 9,381
----------- -----------
Long-term liabilities:
Long-term debt 5,110 -
----------- -----------
Total liabilities 30,363 9,381
----------- -----------
Commitments and contingencies ( Notes 5, 7 and 9)
Shareholders' equity:
Preferred stock, $.01 par value, 10,000,000 shares authorized;
no shares issued and outstanding as of September 30, 1997
and December 31, 1996 - -
Common stock, $.01 par value, 100,000,000 shares authorized;
16,655,000 shares issued and outstanding as of September 30, 1997
and December 31, 1996 166 166
Additional paid-in capital 50,437 50,074
Retained earnings 5,597 2,046
----------- -----------
Total shareholders' equity 56,200 52,286
----------- -----------
Total liabilities and shareholders' equity $ 86,563 $ 61,667
=========== ===========
See accompanying notes to unaudited Consolidated Financial Statements
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
XLConnect Solutions, Inc. and Subsidiaries
Consolidated Statements of Income
(In thousands, except per share data)
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
1997 1996 1997 1996
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenues $ 33,552 $ 31,644 $103,174 $ 83,645
Cost of revenues 22,521 21,905 70,639 58,279
-------- -------- -------- --------
Gross profit 11,031 9,739 32,535 25,366
Operating expenses:
Selling and marketing 3,223 2,511 9,295 6,260
General and administrative 4,666 3,681 14,035 8,790
Depreciation and amortization 929 1,081 3,145 3,572
-------- -------- -------- --------
8,818 7,273 26,475 18,622
-------- -------- -------- --------
Income from operations 2,213 2,466 6,060 6,744
Other income (expense), net:
Interest 150 (1,022) 225 (3,081)
Gain on sale of PBTH 1,546 - 1,546 -
Other (97) (1) (69) (17)
-------- -------- -------- --------
1,599 (1,023) 1,702 (3,098)
-------- -------- -------- --------
Income before income taxes 3,812 1,443 7,762 3,646
Provision for income taxes 2,319 740 4,211 1,929
-------- -------- -------- --------
Net income $ 1,493 $ 703 $ 3,551 $ 1,717
======== ======== ======== ========
Earnings per common share
Net income per common share $ 0.09 $ 0.05 $ 0.21 $ 0.12
Weighted average number of common shares 17,265 13,888 16,942 13,888
See accompanying notes to unaudited Consolidated Financial Statements
/TABLE
<PAGE>
<TABLE> <CAPTION>
XLConnect Solutions, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(In thousands)
(unaudited)
Nine Months Ended
September 30,
-----------------
1997 1996
------- -------
Cash flows from operating activities:
<S> <C> <C>
Net income $ 3,551 $ 1,717
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Depreciation and amortization 3,145 3,572
Gain on sale of PBTH (1,546) -
Loss on disposal of property and equipment 16 17
Provision for allowance on trade accounts receivable 173 129
Amortization of debt discount 47 -
Deferred income taxes (361) 1,002
Changes in assets and liabilities, net of effects of sale of PBTH:
Trade accounts receivable (9,330) (4,725)
Prepayments and other current assets (538) (1,803)
Other long-term assets (704) 42
Accounts payable (556) (15)
Accrued expenses 2,750 3
Deferred income and other (459) (227)
Due to parent 12,460 -
------- -------
Net cash provided by (used in) operating activities 8,648 (288)
------- -------
Cash flows from investing activities:
Purchases of property and equipment (3,029) (3,041)
Proceeds from sale of PBTH 9,283 -
------- -------
Net cash provided by (used in) investing activities 6,254 (3,041)
------- -------
Cash flows from financing activities:
Repayments of long-term debt (46) (129)
Borrowings of long-term debt 5,500 -
Net changes in due to parent - 3,458
Payment of initial public offering costs (74) -
------- -------
Net cash provided by financing activities 5,380 3,329
------- -------
Net change in cash and cash equivalents 20,282 -
Cash and cash equivalents-beginning of period 3,467 -
------- -------
Cash and cash equivalents-end of period $23,749 $ -
See accompanying notes to unaudited Consolidated Financial Statements
/TABLE
<PAGE>
XLConnect Solutions, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share data)
(unaudited)
Note 1. Basis of Presentation
The accompanying Consolidated Financial Statements include the accounts of
XLConnect Solutions, Inc. (the Company or XLConnect) and its wholly-owned
subsidiaries. All material transactions between entities included in these
financial statements have been eliminated. Prior to January 1, 1996, the
Company had no separate legal status or existence. The Company was
incorporated under the laws of the Commonwealth of Pennsylvania in January
1996 and issued 1,000 shares of Common Stock to Intelligent Electronics,
Inc. (IE) at such time in connection with its initial capitalization. The
Company changed its name to XLConnect Solutions, Inc. in May 1996. In
addition (i) as of May 31, 1996, IE contributed to the Company the stock of
IntelliCom Solutions, Inc. (IntelliCom), formerly a wholly-owned subsidiary
of IE, and the assets and liabilities, including debt, relating to the
Professional Services Organizations of The Future Now, Inc. and IE, and
began accumulating its retained earnings, (ii) the Company and IE entered
into certain contractual arrangements effective as of the date set forth on
each agreement for the purpose of defining certain relationships between
them (see Note 7) and (iii) on September 6, 1996, the Company effected a
13,325-for-1 stock split of the Company's issued and outstanding shares of
Common Stock. On October 17, 1996, the Company consummated an initial
public offering (IPO) of 3,330,000 of its authorized and unissued shares of
Common Stock, or approximately 20% of the Company's outstanding shares
after the IPO, at an initial public offering price of $15 per share.
Approximately $41,000 of the total net proceeds of $45,110 were used to
repay the Company's then outstanding indebtedness to IE, with the remaining
proceeds used for working capital and general corporate purposes. As a
result of the IPO, the Company currently is an indirect, 80%-owned
subsidiary of IE.
The Consolidated Financial Statements include historical assets,
liabilities, sales and expenses directly related to the Company's
operations that were either specifically identifiable or allocable using
methods which took into consideration personnel, business volume or other
appropriate factors. For the periods presented, certain general and
administrative expenses reflected in the Consolidated Financial Statements
include allocations of certain corporate expenses from IE. These
allocations generally include administrative expenses related to general
management, insurance, information management and other miscellaneous
services. Allocations of corporate expenses are estimates based on
management's best estimate of actual expenses. Interest expense for the
nine months ended September 30, 1996 reflects interest expense associated
with the Company's share of the aggregate borrowings of IE and all of its
subsidiaries. Income taxes were calculated on a separate tax return basis.
Management believes that the allocations in its Consolidated Financial
Statements are reasonable.
Prior to January 1, 1997, the Company participated in IE's central cash
management system which resulted in all cash that was generated from and
required to support the Company's operations being deposited and received
through IE's corporate operating cash accounts. As a result, there were no
separate bank accounts or accounting records for these transactions.
Accordingly, the amounts represented by the caption "Net changes in due to
parent" to the Company's Consolidated Statements of Cash Flows represent
the net effect of all cash transactions between the Company and IE.
The financial information included herein may not necessarily reflect the
financial position, results of operations or cash flows of the Company in
the future or what the balance sheets, results of operations or cash flows
of the Company would have been if it had been a separate, stand-alone
publicly-held corporation during the nine months ended September 30, 1996.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
use assumptions that affect certain reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from
those estimates.
This information is unaudited but, in the opinion of management, reflects
all adjustments, consisting of normal recurring adjustments, necessary for
a fair presentation of the financial position and operating results for the
interim periods presented. These financial statements should be read in
conjunction with the audited financial statements and notes thereto
included in the Company's Annual Report on Form 10-K for the year ended
December 31, 1996.
Certain amounts in the prior year have been reclassified to conform with
the current year's presentation.
<PAGE>
XLConnect Solutions, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share data)
(unaudited)
Note 2. New Accounting Standards
In February 1997, the Financial Account Standards Board issued Statement of
Financial Accounting Standards No. 128, Earnings per Share (SFAS No. 128)
which is effective for financial statements issued for periods ending after
December 15, 1997. SFAS No. 128 simplifies the previous standards for
computing earnings per share and requires restatement of all prior periods
presented and discloses basic and diluted earnings per share. The
implementation of FSAS No. 128 is not expected to have a material effect on
the Company's calculation of net income per common share.
Note 3. Revenue and Cost Recognition
Revenues from internetworking and applications development service
contracts are primarily recognized as services are provided to the client
and billed on a time and materials basis, and to a lesser extent, are
recognized on the percentage-of-completion basis for fixed price contracts.
Costs are recognized as incurred. Revenues associated with managed service
contracts are recorded ratably over the service period of the contract
while costs are also recognized as incurred. Revenues and costs from
telecommunications services are recognized on the basis of client usage or
pursuant to a fixed rate. The Company is transitioning its
telecommunications services over to a sales agent model where revenues will
be recognized at time of sale. Funds received through IE or directly from
vendors for training, capital expenditures and marketing programs are
accounted for either as fee income or as a reduction of cost of revenues,
capitalized costs or selling and marketing expenses, according to the
nature of the program when earned. The Company received allocations of
IE's total vendor funding related to the businesses of the Company in the
amounts of $1,040 and $883 for the nine months ended September 30, 1997 and
1996, respectively. These allocations were based on the relationship of
services business volumes to total business volumes of the Company and TFN
for 1996 except for funding specifically related to IntelliCom's
telecommunications services. The Company and IE renegotiated the basis of
this allocation for 1997 based on the Company's contribution to IE's
generation of vendor funding. Effective July 1, 1997, the Company began
recognizing a fee of $225 per month from IE for managing its operations
(see Note 7).
Note 4. Sale of Specified Service Contracts and Related Assets
On July 18, 1997, XLConnect and IE completed a transaction (the
Transaction) with GE Capital Information Technology Solutions Acquisition
Corp. (Buyer), a subsidiary of GE Capital Information Technology Solutions,
Inc. (GECITS), whereby XLConnect sold to Buyer specified "Power-by-the-
Hour" (PBTH)managed service contracts and related assets, consisting
principally of accounts receivable and fixed assets. In the transaction,
IE also sold the majority of its direct computer sales operations to Buyer.
The transaction was pursuant to an Asset Purchase Agreement dated July 1,
1997, as amended on July 18, 1997, the closing date (the Purchase
Agreement). The Purchase Agreement includes mutual one year non-
competition and no-hire provisions between the parties.
Of the total purchase price of approximately $136,000 paid by Buyer in the
transaction, the Company received $9,283 (based on the estimated net book
value of the assets sold of approximately $4,530). The purchase price is
subject to adjustment after closing based on the actual net book value of
such assets as of the closing date. A portion of the purchase price due to
IE was placed in escrow pending receipt of certain third-party consents and
to fund purchase price adjustments and obligations of IE and the Company
under the Purchase Agreement, including the obligation to repurchase from
Buyer any transferred accounts receivable which remain uncollected after
120 days following the closing date.
The Company has agreed to repay IE for any of the Company's accounts
receivable required to be repurchased by IE and for certain other
liquidated damages incurred by IE to Buyer as a result of the non-
performance of certain undertakings by the Company in the Purchase
Agreement. The Company has also agreed to reimburse IE for any losses by
reason of the indemnification undertakings in the Purchase Agreement
arising out of or based upon misrepresentations or material breaches of
covenants in the Purchase Agreement by the Company. IE has agreed to
indemnify, defend and hold harmless the Company from any claim asserted
against or liability imposed on the Company under the Purchase Agreement
arising out of or based upon misrepresentations or material breaches of
covenants in the Purchase Agreement by IE.
<PAGE>
XLConnect Solutions, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share data)
(unaudited)
Note 4. Sale of Specified Service Contracts and Related Assets, continued
Pro forma results of operations of the Company for the three and nine
months ended September 30, 1997 and 1996, assuming the Transaction was
consummated on January 1, 1996, are as follows:
Three Months Nine Months
Ended September 30, Ended September 30,
------------------- -------------------
1997 1996 1997 1996
------- ------- ------- -------
Revenues $32,708 $27,257 $92,402 $72,708
Net income 1,141 407 3,237 1,287
Net income per common share 0.07 0.03 0.19 0.09
Pro forma financial information presented above is not necessarily
indicative of the results of operations that would have occurred had the
Transaction taken place at the beginning of the periods presented or of
future results of operations.
Note 5. Debt Obligations
During October 1996, IE and IBMCC amended IE's Credit Facility to allow the
Company to borrow directly from IBMCC up to $20,000 of the total $225,000,
subject to a collateral-based formula (the Sub-facility), and to limit the
Company's joint and several liability with IE to IBMCC to up to $20,000
(whether arising from direct borrowings or a guaranty of IE's borrowings).
As of March 26, 1997, the Company, IE and IBMCC further amended IE's Credit
Facility to terminate the Sub-facility (including the Company's joint and
several liability to IE), and the Company and IBMCC entered into a separate
credit agreement providing the Company with a credit facility in the amount
of $25,000, subject to a collateral-based formula, which is secured by all
of the assets of the Company and its subsidiaries (the XLC Credit
Facility). Interest is payable at LIBOR plus 1.5% decreasing to 1.2%
depending upon outstanding borrowings. The Company was in compliance with
its covenants during the period and, as of September 30, 1997, the Company
had no outstanding borrowings under the XLC Credit Facility. In addition,
IE was required by IBMCC to guarantee any borrowings under the XLC Credit
Facility. Concurrent with establishing the XLC Credit Facility, the
Company and IE have amended and restated their Intercompany Debt Agreement
whereby IE will reimburse the Company for the difference between LIBOR plus
.75% and the interest rate paid by the Company to IBMCC and for other
direct expenses that the Company would not have been required to incur if
it had entered into an unsecured credit facility.
On February 28, 1997, the Company entered into a transaction with a third
party whereby the third party agreed to provide an unsecured loan of up to
$11,000 (the Loan) to be used for specific business purposes. The Company
borrowed the full $5,500 available under the first traunch, which remained
outstanding as of September 30, 1997. The remaining amount may be drawn
after August 28, 1997 and prior to February 28, 1998. Interest is payable
at an initial annual rate of 4% for the first two years and adjusts to 5%
and then 6% for the remaining term. Principal payments of $750 will be
made quarterly beginning in August 1999 with a final payment of $1,250 due
on August 28, 2002. In connection with the Loan, the Company issued to the
third party a warrant to purchase up to 325,000 shares of its Common Stock,
which becomes exercisable on February 28, 1998, August 28, 1998 or February
28, 2002, depending upon the occurrence of certain events, at a per share
exercise price of $6.65, and expires on February 27, 2007. After
considering the effect of the additional interest associated with the
issuance of the warrant and the resultant discounting of the Loan, the
effective interest rate is 7.4%.
Note 6. Net Income Per Common Share
Net income per common share is based on the weighted average number of
outstanding shares of Common Stock for each period. The per share
calculations for the three and nine months ended September 30, 1996 include
the effect of the Company's 13,325-for-1 stock split of Common Stock prior
to the IPO.
<PAGE>
XLConnect Solutions, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share data)
(unaudited)
Note 7. Related Party Transactions
The Company and IE have entered into a number of agreements, in addition to
the Amended and Restated Intercompany Debt Agreement and the agreement
providing for mutual indemnities arising from the Transaction referred to
herein, for the purpose of defining certain relationships between them. As
a result of IE's approximately 80% ownership interest in the Company, the
terms of such agreements were not, and the terms of any future amendments
to those agreements may not be, the result of arms-length negotiation. The
following summaries of these agreements are qualified in all material
respects by the terms and conditions of the agreements.
The "Due to Parent" balance of $12,717 at September 30, 1997 represents the
net payable to IE for the services provided by IE to XLConnect under the
Services, Space Sharing and Tax Allocation Agreements described below as
well as amounts received by XLConnect from shared customers of IE and
XLConnect for product sold by IE. These amounts have been paid in full
subsequent to September 30, 1997.
Services Agreement
The Company and IE have agreed to an Amended and Restated Services
Agreement (Services Agreement) pursuant to which IE will continue, on an
interim basis, to provide the Company, upon the Company's request, various
services, including insurance coverage, employee benefit plan coverage,
human resources administration and tax management services, that IE has
historically provided to the Company. The Company will pay the direct
costs of services provided by IE; to the extent that the direct costs of
services provided by IE cannot be separately measured, the Company will pay
its allocable portion of the total cost to IE for any such services,
determined in accordance with described methodologies, using such objective
factors as are available to IE and the Company. In addition, effective
July 1, 1997, the Company assumed for IE and its subsidiaries certain
management responsibilities as a result of IE's restructuring in which it
sold its indirect computer product business and the majority of its direct
computer product business. IE has agreed to pay the Company a fee of $225
per month for such services. The Services Agreement will automatically
terminate on (i) the occurrence of a pro rata distribution to IE's
shareholders of its remaining shares by means of a tax-free or taxable
transaction (the Distribution) or (ii) such time that IE no longer owns a
majority of the outstanding shares of Common Stock. In addition, the
Services Agreement may also be terminable by either party on 90 days' prior
written notice. Under the Services Agreement, IE and the Company each have
the option to make advances from time to time to the other upon request.
In the case of the Company, such advances would be made as directed or
within specific parameters prescribed by its Board of Directors. Upon
termination of the Services Agreement, all outstanding advances and accrued
but unpaid interest will become due and payable.
In addition, the Services Agreement provides that IE will permit employees
of the Company to continue to participate in the benefit plans and programs
sponsored by IE until the termination of the Services Agreement.
The Services Agreement also recognizes that IE's remaining direct sales
force may continue to provide to the Company sales leads and referrals.
The Services Agreement provides that the Company shall continue to
compensate IE at least through December 31, 1997 for such leads and
referrals that result in revenues to the Company in a manner consistent
with and substantially similar to then current practices between the
companies.
The Services Agreement further provides that the Company will continue to
receive from IE for an interim period, consistent with past practices, a
portion of the funds received by IE from vendors for training, capital
expenditures and marketing programs. The Company and IE have renegotiated
the basis of the Company's allocation of vendor funding for 1997 based on
the Company's relative contribution to the generation of the funding.
<PAGE>
XLConnect Solutions, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share data)
(unaudited)
Note 7. Related Party Transactions, continued
Space Sharing Agreement
The Company and IE have entered into a Space Sharing Agreement providing
for the sharing by the Company and IE of certain office facilities,
including the offices located in Exton, Pennsylvania at which the Company's
and IE's principal executive offices are located. Under the Space Sharing
Agreement, the costs associated with leasing and maintaining facilities
will, in general, be allocated between the Company and IE on a pro rata
basis determined by the square footage utilized by each Company or the
number of employees of each Company at the specified location, in
accordance with historical practice. The Company's rights to use portions
of the shared facilities leased from third parties and the corresponding
obligations to pay for such use, may be terminated as to any facility by
either the Company or IE on 90 days' prior written notice.
Tax Allocation Agreement
The Company and IE have entered into a Tax Allocation Agreement to provide
for (i) the allocation of payments of taxes for periods during which the
Company and IE are included in the same consolidated group for Federal
income tax purposes or the same consolidated, combined or unitary tax
returns for state, local or foreign tax purposes, (ii) the allocation of
responsibility for the filing of tax returns, (iii) the conduct of tax
audits and the handling of tax controversies, and (iv) various related
matters. For periods during which the Company is included in the
aforementioned returns, the Company will be required to pay IE its
allocable share of any tax benefit attributable to the use of IE's losses,
if any.
Indemnification Agreement
The Company and IE have entered into an Indemnification Agreement under
which, among other things and subject to limited exceptions, the Company is
required to indemnify IE and its directors, officers, employees, agents and
representatives for all liabilities relating to the Company's business and
operations and for all liabilities arising out of or based upon alleged
misrepresentations in or omissions from the Registration Statement relating
to the IPO. The Indemnification Agreement also provides that each party
thereto (the Obligor Party) (i) will use reasonable efforts to obtain the
release of the other party thereto (the Guarantor Party) from its
obligations under or in respect of all material guarantees, surety and
performance bonds, letters of credit and other arrangements guaranteeing or
securing any liability or obligation of the Obligor Party (except with
respect to the Company's obligations under the Sub-facility and IE's
guarantee obligations with respect to the XLC Credit Facility that replaces
the Sub-facility), (ii) will indemnify the Guarantor Party for any
liabilities incurred under such guarantees, bonds, letters of credit and
other arrangements, and (iii) will reimburse the Guarantor Party for its
direct costs (or, in certain circumstances, the Obligor Party's pro rata
share of such direct costs) of maintaining such guarantees, bonds, letters
of credit and other arrangements pending the release of the Guarantor Party
thereunder.
Stock Registration and Option Agreement
Pursuant to the terms of the Stock Registration and Option Agreement with
IE, subject to certain limitations, the Company has provided IE with
certain registration rights, including demand registration rights and
"piggy-back" registration rights, with respect to Common Stock owned by IE
after the IPO.
The Company is obligated to pay all expenses incidental to such
registration, excluding underwriters' discounts and commissions and certain
legal fees and expenses. This agreement also grants to IE until the
earlier to occur of (i) the completion of a distribution by IE to its
shareholders of the shares of Common Stock of the Company held by IE (the
Distribution) and (ii) the sale by IE of such number of shares of Common
Stock that IE is no longer eligible to make the Distribution tax free or
to include the Company in IE's consolidated Federal income tax return, a
continuous, cumulative option exercisable only upon the original issuance
of shares by the Company, to purchase from the Company at then-current
market prices such number of shares of Common Stock as necessary for IE to
continue to own at least 80% of the outstanding shares of Common Stock.
The option may only be exercised upon the original issuance of shares by
the Company. In the event that any shares of Common Stock are issued prior
to the Distribution upon the exercise of any option granted under the
Company's 1996 Long-Term Incentive Plan and
<PAGE>
XLConnect Solutions, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share data)
(unaudited)
Note 7. Related Party Transactions, continued
such issuance would otherwise prevent IE from continuing to include the
Company in IE's consolidated Federal income tax return or effecting the
Distribution on a tax-free basis, the option described in the immediately
preceding sentence will automatically be deemed to have been exercised in
respect of a number of shares of Common Stock equal to four times the
number of shares of Common Stock issued upon the exercise of the option
granted under the 1996 Long-Term Incentive Plan unless IE shall have
earlier terminated such automatic exercise feature.
Existing Telecommunications Services Agreement
Pursuant to the terms of a services agreement between IE and the Company
dated as of January 1, 1996, IE has agreed to purchase from the Company all
of the telecommunications services required by IE. The services provided
by the Company under the services agreement involve the transmission of
voice, data, video and other information as well as enhanced
telecommunication services such as frame relay and asynchronous transfer
mode transmission services. The services provided by the Company also
include capacity planning, call accounting, network design and similar
services. Total revenues received from IE were $2,374 and $2,898 for the
nine months ended September 30, 1997 and 1996, respectively. The services
agreement requires IE to purchase sufficient telecommunications services to
permit the Company to meet the minimum volume requirements imposed by the
Company's agreement with MCI Telecommunications Corporation (MCI). The
services agreement has a term of five years and will renew automatically
for six successive two year periods, unless terminated earlier in
accordance with its terms. IE may terminate the services agreement at the
conclusion of any such term if it provides the Company with at least 90
days' notice prior to the expiration of such term that it has received a
bona fide offer to provide telecommunications services that in quantity,
quality and duration are equal to or better than the services being
provided to IE by the Company at a price of 5% or more below the price the
Company charges for such services and the Company does not match the offer.
Note 8. Supplemental Cash Flow Information
Non-cash financing activities of $437 for the nine months ended September
30, 1997 related to the discounting of the Loan as a result of issuing
detachable warrants (see Note 5). Cash payments were $76 for interest and
$540 for income taxes which includes $420 paid to IE under the Tax
Allocation Agreement for the nine months ended September 30, 1997. The
Company made no cash payments for interest and income taxes for the nine
months ended September 30, 1996.
Note 9. Contingencies
The Company continuously evaluates contingencies based upon the best
available evidence. Management believes that allowances for loss have been
provided to the extent necessary and that its assessment of contingencies
is reasonable.
The Company, through IntelliCom, entered into an agreement with MCI in
December 1994, whereby the Company is authorized to sell certain of MCI's
data and voice communications services under the Company's name. This
relationship generates recurring revenues for the Company from clients'
monthly usages. The Company is required to meet a certain minimum billing
level of $2,000 in 1997, or pay MCI the shortfall. The Company has
exceeded its minimum under this agreement in the past and believes that it
will exceed its minimum in 1997.
<PAGE> <PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Results of Operations
Three and Nine Months Ended September 30, 1997 Compared to Three and Nine
Months Ended September 30, 1996.
The following table sets forth the components of revenues of the Company
for the periods presented:
<TABLE> <CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
---------------------------------- ------------------------------------
1997 1996 (1) 1997 1996 (1)
---------------------------------- ------------------------------------
% of % of % of % of
Amount Revenue Amount Revenue Amount Revenue Amount Revenue
-------- ------- -------- ------- -------- ------- -------- -------
Revenues:
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Internetworking $ 10,642 31.7% $ 9,812 30.0% $ 31,503 30.5% $ 25,591 30.6%
Applications development 6,098 18.2 4,732 15.0 17,716 17.2 12,824 15.3
Managed services 13,384 39.9 12,300 38.9 39,303 38.1 32,378 38.7
Telecommunications and
other fees 3,428 10.2 4,800 15.2 14,652 14.2 12,852 15.4
---------------- ---------------- ----------------- ----------------
Total Revenues $ 33,552 100.0% $ 31,644 100.0% $103,174 100.0% $ 83,645 100.0%
================ ================ ================= ================
</TABLE>
_________________
(1) Restated to reflect current years presentation
Revenues. Revenues increased 6.0% for the quarter ended September 30, 1997
to $33.6 million from $31.6 million for the quarter ended September 30,
1996. The increase was attributable to growth in most of the Company's
service areas combined with fees received from IE of $675,000 for
management responsibilities assumed by the Company in connection with the
completion of IE's restructuring resulting from the sale of its indirect
computer product business and the majority of its direct computer product
business. Offsetting these increases were the sale of specified PBTH
managed service contracts which included the Company's largest account,
General Electric Aircraft Engines, and the decrease in telecommunications
services sold to IE as a result of its dispositions.
Revenues increased 23.3% for the nine months ended September 30, 1997 to
$103.2 million from $83.6 million for the nine months ended September 30,
1996. The increase was attributable to growth in all of the Company's
service areas, partially offset by the sale of the PBTH contracts and the
impact on the Company from IE's sale of the indirect business and the
majority of its direct business.
Cost of Revenues. Cost of revenues increased 2.8% for the quarter ended
September 30, 1997 to $22.5 million from $21.9 million for the quarter
ended September 30, 1996. This increase was primarily the result of an
increased number of technical personnel needed to support the growth in
revenues along with the associated training costs necessary to build
dedicated Microsoft and IBM/Lotus service practices; offset by the effect
of the decrease in PBTH and telecommunication services revenues associated
with the sales described above. Cost of revenues as a percentage of
revenues decreased to 67.1% for the quarter ended September 30, 1997 from
69.2% for the quarter ended September 30, 1996. This improvement is
primarily due to the sale of certain low margin PBTH managed service
contracts and the recognition of fees from IE for managing its operations
after the restructuring.
Cost of revenues increased 21.2% for the nine months ended September 30,
1997 to $70.6 million from $58.3 million for the nine months ended
September 30, 1996. This increase was primarily the result of an increased
number of technical personnel needed to support the growth in revenues
combined with incremental costs associated with increased revenues from the
Company's PBTH program prior to the Transaction. Cost of revenues as a
percentage of revenues decreased to 68.5% for the nine months ended
September 30, 1997 from 69.7% for the nine months ended September 30, 1996,
resulting from an improvement in the utilization of the Company's engineers
and technicians and the sale of certain low margin managed service
contracts. These improvements were partially offset by the pricing
adjustments made to the Company's largest contract.
Selling and Marketing. Selling and marketing expenses increased 28.3% for
the quarter ended September 30, 1997 to $3.2 million from $2.5 million for
the quarter ended September 30, 1996 and increased as a percentage of
revenues to 9.6% for the quarter ended September 30, 1997 from 7.9% for the
quarter ended September 30, 1996. Selling and marketing expenses increased
48.5% for the nine months ended September 30, 1997 to $9.3 million from
$6.3 million for the nine months ended September 30, 1996 and increased as
a percentage of revenues to 9.0% for the nine months ended September 30,
1997 from 7.5% for the nine months ended September 30, 1996. The increase
in both comparison periods resulted from the continued development of the
Company's direct sales force combined with incremental promotional and
advertising costs associated with the Company developing its name and
service offerings within the marketplace.
General and Administrative. General and administrative expenses increased
26.8% for the quarter ended September 30, 1997 to $4.7 million from $3.7
million for the quarter ended September 30, 1996 and increased as a
percentage of revenues to 13.9% for the quarter ended September 30, 1997
from 11.6% for the quarter ended September 30, 1996. General and
administrative expenses increased 59.7% for the nine months ended September
30, 1997 to $14.0 million from $8.8 million for the nine months ended
September 30, 1996 and increased as a percentage of revenues to 13.6% for
the nine months ended September 30, 1997 from 10.5% for the nine months
ended September 30, 1996. The increase in both comparison periods was due
to the continued separation of XLConnect from IE's direct business with
which XLConnect shared certain facilities and related expenses, as well as
the Company's growth and new market expansion. Overhead costs also
increased in order to support the Company's growth and to enable it to
operate as a separate public company. The overhead costs include an
expanded management and operations team, associated employee benefits and
insurance costs. The Company anticipates continued pressure on general and
administrative expenses in regards to final separation from IE's direct
computer product sales business.
Depreciation and Amortization. Depreciation and amortization decreased
14.0% for the quarter ended September 30, 1997 to $929,000 from $1.1
million for the quarter ended September 30, 1996 and decreased as a
percentage of revenues to 2.8% for the quarter ended September 30, 1997
from 3.5% for the quarter ended September 30, 1996. Depreciation and
amortization decreased 11.9% for the nine months ended September 30, 1997
to $3.1 million from $3.6 million for the nine months ended September 30,
1996 and decreased as a percentage of revenues to 3.0% for the nine months
ended September 30, 1997 from 4.2% for the nine months ended September 30,
1996. The decrease was due to more assets becoming fully depreciated
during the comparable periods than capital additions made combined with the
write-off of goodwill specifically associated with the Transaction.
Income from Operations. Income from operations decreased 10.3% for the
quarter ended September 30, 1997 to $2.2 million from $2.5 million for the
quarter ended September 30, 1996 and decreased as a percentage of revenues
to 6.6% for the quarter ended September 30, 1997 from 7.8% for the quarter
ended September 30, 1996. Income from operations decreased 10.2% for the
nine months ended September 30, 1997 to $6.1 million from $6.7 million for
the nine months ended September 30, 1996 and decreased as a percentage of
revenues to 5.9% for the nine months ended September 30, 1997 from 8.1% for
the nine months ended September 30, 1996, due to the increase as a
percentage of revenues of selling and marketing and general and
administrative expenses for the reasons stated above.
Other Income (Expense), Net. The Company recognized other income of $1.6
million for the quarter ended September 30, 1997 in contrast to other
expense of $1.0 million for the quarter ended September 30, 1996, and
recognized other income of $1.7 million for the nine months ended September
30, 1997 as compared to the recognition of other expense of $3.1 million
for the nine months ended September 30, 1996. The change in both
comparison periods is a result of the combination of recognizing a gain on
the sale of the PBTH contracts and related assets in the Transaction and
paying off the Company's then outstanding borrowings from IE with the
proceeds of the IPO while investing the remaining net proceeds from the IPO
and the proceeds from the Loan in short-term securities which generated
interest income.
Provision for Income Taxes. Provision for income taxes increased 213.3% for
the quarter ended September 30, 1997 to $2.3 million from $740,000 for the
quarter ended September 30, 1996. The effective income tax rate increased
to 60.9% for the quarter ended September 30, 1997 from 51.3% for the
quarter ended September 30, 1996. The provision for income taxes increased
118.3% for the nine months ended September 30, 1997 to $4.2 million from
$1.9 million for the nine months ended September 30, 1996. The effective
income tax rate increased to 54.3% for the nine months ended September 30,
1997 from 52.9% for the quarter ended September 30, 1996. The increase in
income taxes for both comparison periods is a result of greater income
before taxes while the effective income tax rates increased due to the
write-off of non-deductible goodwill associated with the Transaction.
Quarterly Results and Seasonality
The Company's quarterly results may vary depending upon a number of
factors, including the following: changes in the levels of revenues
derived from internetworking, applications development, managed services
and telecommunication fees and other services; the size and timing of
significant projects; changes in the mix of employee and subcontractor
technicians; the number of business days in a period and the closing of
client facilities for holidays and other reasons; cost overruns on fixed-
price contracts; the potential for increased expenditures and the loss of
sales generation activity resulting from the sale of the majority of the
direct computer sales business of IE with which XLConnect shared facilities
and related expenses, employee benefits, insurance policies and other
services and has relied on significantly for sales leads; business
distractions resulting from the relocation of six branch locations due to
the sale of IE's direct computer sales business and other business reasons;
the timing of new service offerings by the Company or its competitors; new
branch office openings by the Company; the loss of senior management or key
technical personnel; changes in pricing policies by the Company or its
competitors; market acceptance of new and enhanced services offered by the
Company or its competitors; changes in operating expenses; the availability
of qualified technical personnel; disruptions in sources of supply of
computer, telecommunications and related products and services; the effect
of acquisitions; and industry and general economic factors. In addition,
the Company believes that its business is subject to some seasonality, and
that weaker sales may be experienced during the fourth and first quarters
due to fewer business days and by some clients' decisions at year end to
postpone large internetworking and applications development projects until
the following year when capital budgets are renewed.
Effects of Inflation
The Company believes it has not been adversely affected by inflation during
the past three years.
Liquidity and Capital Resources
The Company's operating activities provided cash of $8.6 million for the
nine months ended September 30, 1997 primarily as a result of the Company
after the close of the period paying IE for services provided by IE under
the Services, Space Sharing and Tax Allocation Agreements and transmitting
cash to IE that the Company had received from shared customers of IE and
XLConnect for products sold by IE. In addition, accrued expenses increased
for reserves established as a result of the Transaction. Offsetting these
increases was an increase in working capital, primarily accounts receivable
resulting from the growth in revenues. The Company believes that it may
use cash from operations through the end of the year because of continued
revenue growth in the Company's business and the associated use of working
capital in connection with this growth.
The Company's investing activities provided cash of $6.3 million for the
nine months ended September 30, 1997 relating to the sales proceeds from
the Transaction. Offsetting the sales proceeds is the use of cash for
capital expenditures necessary to support the continued growth of technical
service and administrative personnel and new market expansion.
The Company's financing activities provided cash of $5.4 million for the
nine months ended September 30, 1997 resulting primarily from borrowings
against the Loan provided by a third party.
Prior to January 1, 1997, the Company participated in IE's central cash
management system, pursuant to which all cash generated from the Company's
operations was transferred to IE on a daily basis, and all cash required to
operate the Company's business was transferred back to the Company from IE.
Consequently, during the nine months ended September 30, 1996 the Company
did not maintain separate cash accounts.
As of March 26, 1997, the Company, IE and IBMCC amended the IE Credit
Facility to terminate the Sub-facility (including the Company's joint and
several liability to IE under the IE Credit Facility), and the Company and
IBMCC entered into a separate credit agreement providing the Company with
the XLC Credit Facility in the amount of $25 million, subject to a
collateral-based formula, which is secured by all of the assets of the
Company and its subsidiaries. Interest is payable at LIBOR plus 1.5%
decreasing to 1.2%, depending upon the amount of outstanding borrowings.
The Company was in compliance with its covenants during the period and, as
of September 30, 1997, the Company had no outstanding borrowings under the
XLC Credit Facility. In addition, IE was required by IBMCC to guarantee
any borrowings under the XLC Credit Facility. Concurrent with establishing
the XLC Credit Facility, the Company and IE Amended and Restated the
Intercompany Debt Agreement whereby IE will reimburse the Company for the
difference between LIBOR plus .75% and the interest rate paid by the
Company to IBMCC and for other direct expenses that the Company would not
have been required to incur if it had entered into an unsecured credit
facility.
Additionally, on February 28, 1997, the Company entered into a transaction
with a third party whereby the third party agreed to provide the Loan in an
amount up to $11 million to be used for specific business purposes. The
Company borrowed the full $5.5 million available under the first traunch,
which remained outstanding as of September 30, 1997. The remaining amount
may be drawn after August 28, 1997 and prior to February 28, 1998.
Interest is payable at an initial annual rate of 4% for the first two years
and adjusts to 5% and then 6% for the remaining term. Principal payments
of $750,000 will be made quarterly beginning in August 1999 with a final
payment of $1.25 million due on August 28, 2002. In connection with the
Loan, the Company issued to the third party a warrant to purchase up to
325,000 shares of its Common Stock, which becomes exercisable on February
28, 1998, August 28, 1998 or February 28, 2002, depending upon the
occurrence of certain events, at a per share exercise price of $6.65, and
expires on February 27, 2007. After considering the effect of the
additional interest associated with the issuance of the warrant and the
resultant discounting of the Loan, the effective interest rate is 7.4%.
On July 18, 1997, XLConnect and IE completed the transaction with Buyer
whereby XLConnect sold to Buyer specified "Power-by-the-Hour" managed
service contracts and related assets, consisting principally of accounts
receivable and fixed assets. In the Transaction, IE also sold the majority
of its direct computer sales operations to Buyer. Of the total purchase
price of approximately $136 million paid by Buyer in the Transaction, the
Company received $9.3 million (based on the estimated net book value of the
assets sold of approximately $4.5 million). The purchase price is subject
to adjustment after closing based on the actual net book value of such
assets as of the closing date.
Forward Looking Statements
The matters discussed in this Form 10-Q that are forward-looking statements
within the meaning of the federal securities laws are based on current
management expectations that involve risks and uncertainties that could
cause actual results to differ materially from expected results. Potential
risks and uncertainties, the occurrence of one or more of which could have
a material adverse effect on the Company, include, without limitation:
risks related to the impact on the Company of the sale by IE of its
indirect computer sales business and the majority of its direct computer
sales operations; the risks of any substantial legal proceedings that could
be instituted in the future; the factors described herein under "Quarterly
Results and Seasonality"; and the risk factors described generally in the
Company's Prospectus dated October 17, 1996 filed with the Securities and
Exchange Commission in connection with the IPO.
<PAGE> <PAGE>
Part II - Other Information
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
2.1 -- Asset Purchase Agreement between GE Capital Information
Technology Solutions Acquisition Corp. and IE and certain
of its subsidiaries dated as of July 1, 1997 (7)
2.2 -- First Amendment to Asset Purchase Agreement between GE
Capital Information Technology Solutions Acquisition Corp.
and IE and certain of its subsidiaries dated as of July
18, 1997 (7)
2.3 - Agreement between the Company, IE and certain of its
subsidiaries dated as of July 18, 1997 relating to
allocation of purchase price and indemnities (7)
3.1 -- Articles of Incorporation of the Company, as amended (2)
3.2 -- By-Laws of the Company (1)
4.1 -- Specimen Stock Certificate (4)
10.1 -- Contribution Agreement between IE, TFN, the Future Now,
Inc. of Arkansas and the Company dated as of May 31, 1996(2)
10.2 -- 1996 Long-Term Incentive Plan (including form of option
agreement) (2)
10.3 -- Services Agreement between the Company, IE and XLSource,
Inc. dated as of October 22, 1996 (5)
10.4 -- Space Sharing Agreement between the Company, IE and TFN,
with respect to the Company's principal executive offices
and branch offices dated as of May 31, 1996 (5)
10.5 -- Tax Allocation Agreement between the Company, IE and IE's
other subsidiaries effective as of January 29, 1995 (5)
10.6 -- Stock Registration and Option Agreement between the Company,
IE and The Future Now, Inc. of Arkansas dated as of May 31,
1996, and Amendment No. 1 thereto dated as of February 28,
1997 (5)
10.7 -- Indemnification Agreement between the Company and IE dated
as of October 22, 1996 (5)
10.8 -- Offer Letters for Executive Officers of the Company (2)
10.9 -- Amended Credit Agreement between IBMCC and IE and the
Company terminating the $20 million Sub-facility and Credit
Agreement between IBMCC and the Company dated as of March
26, 1997 (6)
10.10 -- Amended and Restated Intercompany Debt Agreement dated as of
March 26, 1997 by and between IE and the Company
10.11 -- Services Agreement for Telecommunications Services by and
between XLConnect Service, Inc. (a wholly-owned subsidiary
of the Company Formerly named IntelliCom Solutions, Inc.)
and IE dated as of January 1, 1996 (5)
10.12 -- Services Practice Agreement between Microsoft Corporation
and the Company dated as of February 28, 1997 (6)
27.1 -- Financial Data Schedule (submitted electronically only to
Securities and Exchange Commission)
(1) Incorporated by reference herein from the Company's Registration
Statement on Form S-1 (No. 333-08735) filed on July 24, 1996.
(2) Incorporated by reference herein from Amendment No. 1 to the
Company's Registration Statement on Form S-1 filed on September 16,
1996.
(3) Incorporated by reference herein from Amendment No. 2 to the
Company's Registration Statement on Form S-1 filed on October 3,
1996.
(4) Incorporated by reference herein from Amendment No. 3 to the
Company's Registration Statement on Form S-1 filed on October 15,
1996.
(5) Incorporated by reference herein from the Company's Quarterly Report
on Form 10-Q filed on December 2, 1996.
(6) Incorporated by reference herein from the Company's Quarterly Report
on Form 10-Q filed on May 15, 1997. The Company has requested and
received confidential treatment for portions of Exhibit 10.12.
(7) Incorporated by reference herein from the Company's Current Report on
Form 8-K filed on August 1, 1997.
(b) Reports filed on Form 8-K.
The Company filed on August 1, 1997 a Current Report on Form 8-K
dated July 18, 1997 reporting, under Item 2, the consummation of the
sale of specified "Power-by-the-Hour" managed service contracts and
related assets and filed an amended Current Report on Form 8-K/A on
September 30, 1997 reflecting pro forma financial information for
the Transaction as if it had been consummated as of January 1, 1996.
<PAGE>
SIGNATURES
----------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Company has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
XLConnect Solutions, Inc.
/s/Timothy W. Wallace
------------------------------------
Timothy W. Wallace
President and
Chief Operating Officer
/s/ Stephanie D. Cohen
------------------------------------
Stephanie D. Cohen
Executive Vice President,
Chief Financial Officer and
Chief Accounting Officer
Date: November 14, 1997
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