<PAGE>
================================================================================
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 June 30, 1997
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 0-21525
Donnelley Enterprise Solutions Incorporated
(Exact name of registrant as specified in its charter)
Delaware 13-316071
(State of Incorporation) (I.R.S. Employer Identification No.)
161 North Clark Street, Suite 2400, Chicago, IL 60601
(Address of principal executive offices including zip code)
Registrant's telephone number, including area code: (312) 419-7600
Indicate by check mark whether the registrant (1) has filed all reports
required 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.
Common Stock, par value $0.01 per share: 5,005,000 shares outstanding as of
August 14, 1997.
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<PAGE>
INDEX
Page
----
Part I--Financial Information
Item 1. Financial Statements
Consolidated Statements of Income for the three and six month
periods ended June 30, 1996 and 1997........................... 1
Consolidated Balance Sheets as of December 31, 1996 and
June 30, 1997.................................................. 2
Consolidated Statements of Cash Flows for the six month periods
ended June 30, 1996 and 1997................................... 3
Notes to Consolidated Financial Statements....................... 4
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations........................................... 6
Item 3. Quantitative and Qualitative Disclosures about Market Risk.... *
Part II--Other Information
Item 1. Legal Proceedings............................................. *
Item 2. Changes in Securities......................................... *
Item 3. Defaults Upon Senior Securities............................... *
Item 4. Submission of Matters to a Vote of Security Holders........... 11
Item 5. Other Information............................................. 11
Item 6. Exhibits and Reports on Form 8-K.............................. 11
__________
*No response to this item is included herein for the reason that it is
inapplicable or the answer to such item is negative.
<PAGE>
PART I--FINANCIAL INFORMATION
Item 1: Financial Statements.
DONNELLEY ENTERPRISE SOLUTIONS INCORPORATED
CONSOLIDATED STATEMENTS OF INCOME
($000s, except per share data)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- -----------------------
1996 1997 1996 1997
--------- --------- --------- ---------
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
Business services outsourcing revenues................. $ 13,594 $ 17,201 $ 26,431 $ 33,557
Information technology revenues........................ 11,198 11,526 18,812 22,208
--------- --------- --------- ---------
Total revenues...................................... 24,792 28,727 45,243 55,765
Cost of revenues....................................... 18,983 21,663 34,908 42,800
--------- --------- --------- ---------
Gross profit........................................ 5,809 7,064 10,335 12,965
Selling, general and administrative expenses........... 4,269 5,552 8,570 10,734
Amortization of goodwill............................... 158 267 306 532
--------- --------- --------- ---------
Earnings from operations............................ 1,382 1,245 1,459 1,699
Interest expense....................................... 65 80 126 72
--------- --------- --------- ---------
Earnings before income taxes........................ 1,317 1,165 1,333 1,627
Income taxes........................................... 626 587 712 813
--------- --------- --------- ---------
Net income.......................................... 691 578 621 814
========= ========= ========= =========
Earnings per share..................................... .12 .16
========= =========
Common shares outstanding.............................. 5,005,000 5,005,000
========= =========
Pro forma earnings per share........................... .14 .12
========= =========
Pro forma common shares outstanding.................... 5,005,000 5,005,000
========= =========
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
1
<PAGE>
DONNELLEY ENTERPRISE SOLUTIONS INCORPORATED
CONSOLIDATED BALANCE SHEETS
($000s, except per share data)
<TABLE>
<CAPTION>
December 31, June 30,
ASSETS 1996 1997
------ ------------ --------
(Unaudited)
<S> <C> <C>
Current assets:
Cash and equivalents........................................................................... $ 8,910 $ 3,514
Accounts receivable, less allowances for doubtful accounts of $460 in 1996 and
$502 in 1997................................................................................. 21,228 22,341
Unbilled receivables, less allowances for doubtful accounts of $0 in 1996 and $100 in 1997..... 4,847 14,899
Inventories.................................................................................... 4,144 3,388
Prepaid expenses and other current assets...................................................... 1,728 1,196
Income taxes receivable........................................................................ 1,533 1,958
Deferred income taxes.......................................................................... 867 957
------- -------
Total current assets......................................................................... 43,257 48,253
Property and equipment, net...................................................................... 12,646 15,359
Goodwill, net.................................................................................... 20,213 19,698
Other noncurrent assets.......................................................................... 60 63
------- -------
Total assets................................................................................. $76,176 $83,373
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
Current liabilities:
Line of credit................................................................................. $ -- $12,000
Capital lease obligations, current portion..................................................... 1,162 1,164
Notes payable, current......................................................................... -- 46
Advances due to related party.................................................................. 6,455 2,893
Accounts payable............................................................................... 7,633 8,033
Accrued salary and benefits.................................................................... 2,280 2,586
Accrued other expenses......................................................................... 2,010 2,269
Customer prepayments........................................................................... 4,434 --
Deferred revenues.............................................................................. 1,134 2,199
------- -------
Total current liabilities.................................................................... 25,108 31,190
Noncurrent liabilities:
Capital lease obligations...................................................................... 1,305 1,592
Deferred income taxes.......................................................................... 311 284
Notes payable.................................................................................. -- 195
------- -------
Total noncurrent liabilities................................................................. 1,616 2,071
Shareholders' equity:
Common stock--$.01 par value, 15,000,000 authorized shares; 5,005,000 issued
and outstanding at December 31, 1996 and June 30, 1997....................................... 50 50
Preferred stock--$.01 par value, 1,000,000 authorized shares; none issued and
outstanding.................................................................................. -- --
Additional paid-in capital..................................................................... 49,399 49,245
Retained earnings.............................................................................. 3 817
------- -------
Total shareholders' equity................................................................... 49,452 50,112
------- -------
Total liabilities and shareholders' equity................................................... $76,176 $83,373
======= =======
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
2
<PAGE>
DONNELLEY ENTERPRISE SOLUTIONS INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
($000s)
<TABLE>
<CAPTION>
Six months ended
June 30,
---------------------------
1996 1997
------------- ------------
<S> <C> <C>
(Unaudited)
Cash flows provided by (used in) operating activities:
Net income....................................................... $ 621 $ 814
Depreciation and amortization.................................... 2,109 2,609
Amortization of goodwill......................................... 306 532
Net changes in assets and liabilities............................ (12,135) (12,843)
-------- --------
Net cash used in operating activities.................... (9,099) (8,888)
-------- --------
Cash flows used in investing activities:
Capital expenditures............................................. (2,139) (4,425)
LANSystems contingent payments................................... (794) --
-------- --------
Net cash used in investing activities.................... (2,933) (4,425)
-------- --------
Cash flows (used for) provided by financing activities:
Advances from (to) related parties, net.......................... 12,965 (3,562)
Repayments/dividends to related party............................ (621) --
Line of credit................................................... -- 12,000
Notes payable.................................................... -- 241
Principal payments on capital leases............................. (666) (607)
Stock issuance costs related to IPO.............................. -- (155)
-------- --------
Net cash provided by financing activities................ 11,678 7,917
-------- --------
Net decrease in cash and equivalents............................. (354) (5,396)
Cash and equivalents, at beginning of period............. 652 8,910
-------- --------
Cash and equivalents, at end of period................... 298 3,514
======== ========
The changes in assets and liabilities were as follows:
Decrease (increase) in assets:
Receivables, net.............................................. $ (5,742) $(11,165)
Inventories................................................... (877) 756
Prepaid expenses and other.................................... 22 532
Income taxes receivable....................................... (89) (425)
Deferred income taxes......................................... 233 (90)
Other noncurrent assets....................................... (2) (20)
Increase (decrease) in liabilities:
Accounts payable.............................................. (891) 400
Accrued salary and benefits................................... (640) 306
Accrued other expenses........................................ (572) 259
Customer prepayments.......................................... (2,745) (4,434)
Deferred income taxes......................................... -- (27)
Deferred revenues............................................. (579) 1,065
Other noncurrent liabilities.................................. (253) --
-------- --------
Net change in assets and liabilities............................. $(12,135) $(12,843)
======== ========
Cash paid during the period for:
Interest......................................................... 126 219
Income taxes..................................................... $ 246 $ 619
======== ========
Supplemental non-cash investing and financing activities:
Capital leases................................................... $ 24 $ 896
======== ========
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
3
<PAGE>
DONNELLEY ENTERPRISE SOLUTIONS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Organization and Nature of Operations
Donnelley Business Services ("DBS") was an unincorporated business unit of
R.R. Donnelley & Sons Company ("R.R. Donnelley") from its organization in 1988
through December 31, 1995. On June 21, 1995, R.R. Donnelley acquired LANSystems,
Inc. ("LANSystems") in a business combination accounted for as a purchase.
Following the acquisition, LANSystems was a wholly owned subsidiary of R.R.
Donnelley and was operated together with DBS. Effective January 1, 1996, R.R.
Donnelley contributed the assets and liabilities of DBS to LANSystems and
LANSystems changed its name to Donnelley Enterprise Solutions Incorporated (the
"Company" or "DESI").
On November 5, 1996, the Company completed an initial public offering of
2,860,000 shares of Common Stock (the "IPO" or "Offering"), 1,855,000 of
which were sold by the Company, and 1,005,000 of which were sold by R.R.
Donnelley. Of the $41.7 million of net proceeds to the Company from the IPO, (1)
approximately $8.7 million was used in final payment for certain contingent
obligations arising from the acquisition of LANSystems, (2) $20.3 million was
used in repayment of advances owed R.R. Donnelley, and (3) approximately $8.1
million was used in repayment of the $8.0 million Dividend Note and accrued
interest. The remaining $4.6 million was used for general corporate purposes.
The Company is a single-source provider of integrated information management
services to professional service providers, primarily large law firms,
investment banking firms and accounting firms. The Company operates entirely
within the information management services segment. Within this segment, the
Company offers two general categories of services: business services outsourcing
and information technology services. The Company's business services outsourcing
offerings include document services, such as reprographic, networked and color
printing, mailroom and facsimile services; word processing and desktop
publishing; and imaging. The Company's information technology services include
systems integration, consulting, software development and systems management
outsourcing.
Note 2. Basis of Presentation and Carve-Out
The financial statements included herein are unaudited and have been prepared
by the Company to conform with the requirements applicable to this Quarterly
Report on Form 10-Q. Accordingly, certain information and disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been omitted as permitted by such requirements.
However, the Company believes that the disclosures made are adequate to make the
information presented not misleading. These financial statements should be read
in conjunction with, and have been prepared in conformity with the accounting
principles reflected in the financial statements and related notes in the
Company's Annual Report on Form 10-K for the year ended December 31, 1996.
Consolidated Financial Statements and other financial data appearing in this
Form 10-Q reflect the results of operations, financial position and cash flows
of the Company on a carve-out basis and are derived from the historical
consolidated financial statements and financial data of the Company. The
consolidated financial statements have been adjusted to reflect certain expenses
and liabilities incurred by R.R. Donnelley on behalf of the Company. The Company
believes that the assumptions underlying all such adjustments are reasonable;
however, the consolidated financial statements do not necessarily reflect the
expenses and liabilities that would have been incurred by the Company operating
as a stand alone entity.
The Company has entered into certain agreements pursuant to which R.R.
Donnelley or its affiliates have agreed to perform certain legal, tax, data
processing, risk management, employee benefit, credit and collection, cash
management, banking and accounts payable services for the Company. The Company
is charged fees and expenses for these services, but retains the right to
terminate certain services provided under the agreements upon 30 days notice.
The interim financial statements herein reflect, in the opinion of the
Company, all normal and recurring adjustments necessary to present fairly the
financial information for the periods presented. Certain items in prior periods
have been
4
<PAGE>
reclassified to conform with current period classifications. The 1997 interim
results are not necessarily indicative of the results that may be expected for
the remainder of the year.
Note 3. Earnings Per Share
Earnings per share is determined by dividing the net income by the weighted
average shares outstanding during the period. The dilutive effect of unexercised
stock options has not been included in the calculation as the effect would not
be material. The pro forma earnings per share calculation for the three and six
months ended June 30, 1996 does not reflect the actual weighted average shares
outstanding during the period, but assumes the 5,000,000 common shares
outstanding upon the completion of the Offering and the 5,000 restricted common
shares issued to a key executive were outstanding for the period.
Note 4. Credit Agreement
The Company entered into a $22.0 million credit agreement with Harris Trust
and Savings Bank on October 30, 1996. The credit agreement is used in
conjunction with cash flows from operations to fund ongoing operations, seasonal
cash needs and for continued growth and investment.
Note 5. Commitments and Contingencies
The Company is party to certain litigation arising in the ordinary course of
business which, in the opinion of management, will not have a material adverse
effect on the operations or financial position of the Company. A former client
filed suit against the Company in 1996 and the Company filed a counterclaim in
1997. The Company is of the opinion that the claim and the related counterclaim
will not have a material impact on the results of operations of the Company in
the period in which resolved.
Note 6. New Accounting Pronouncement
In February of 1997, Statement of Financial Accounting Standards No. 128,
"Earnings per Share" ("FAS 128") was issued. FAS 128 simplifies the standards
for computing earnings per share. FAS 128 is effective for financial statements
issued for periods ending after December 15, 1997, including interim periods.
FAS 128 requires restatement of all prior-period EPS data presented. Management
believes the adoption of FAS 128 in the fourth quarter will not have a material
impact on the financial statements of the Company.
5
<PAGE>
Item 2: Management's Discussion and Analysis of Financial Condition and Results
of Operations.
General
Overview
The Company is a single-source provider of integrated information management
services to professional service organizations, primarily large law firms,
investment banks and accounting firms. DESI offers its clients the opportunity
to focus on their core businesses by outsourcing a variety of functions,
including business services and information technology services. The Company has
experienced substantial growth by expanding its service offerings, adding new
clients, increasing business with its existing clients, and capitalizing on the
growing trend toward outsourcing. In the three months ended June 30, 1997, the
Company's revenues from business services outsourcing and information technology
services were $17.2 million and $11.5 million, respectively, compared to $13.6
million for business services outsourcing and $11.2 million from information
technology services for the same period of 1996. In the six months ended June
30, 1997, the Company's revenues from business services outsourcing and
information technology services were $33.6 million and $22.2 million,
respectively, compared to $26.4 million for business services outsourcing and
$18.8 million from information technology services for the same period of 1996.
DESI commenced its outsourcing operations in 1988 as a provider of
reprographic services and has expanded its service offerings to include
networked and electronic color printing, mailroom and facsimile services, word
processing, desktop publishing and imaging. In June 1995, the Company broadened
its capabilities from managing paper-based information to include the management
of electronic information through the acquisition of LANSystems, which has
provided information technology services, including systems integration,
consulting and software development, since 1983. In February 1996, the Company
began providing systems management outsourcing services.
The Company's revenues are derived primarily from (i) monthly fees under its
business services outsourcing contracts, (ii) fees relating to both information
technology and technical training projects, (iii) the resale of hardware or
software products, (iv) monthly fees under its system management outsourcing
contracts, and (v) monthly fees under information technology maintenance
contracts. The Company typically enters into contracts with its business
services clients that have terms ranging from three to five years. These
contracts generally provide for monthly minimum payments based on the client's
historical volumes. Substantially all of the Company's business services
outsourcing contracts are priced on a per unit basis for each service provided
and allow for annual increases or decreases of the unit pricing for each of the
outsourcing services provided in order to reflect actual costs of labor,
equipment and supplies. System management contracts are priced on a monthly
fixed fee basis, plus a fee for overtime and additional services. The majority
of the Company's other information technology projects are priced on a fixed-fee
basis, although some work is contracted on a time-and-materials basis. Contracts
for information technology projects typically include scope of work and
acceptance criteria for identifying project completion. The Company typically
seeks to obtain an increase in its fees if a client makes any significant change
to the original scope of a project. Payment terms for these contracts include a
down payment, and invoices are submitted in accordance with the achievement of
negotiated milestones or dates during the projects.
Increased penetration in the Company's target markets is a key element in its
growth strategy. Cross-selling within the Company's existing client base
resulted in two new systems management outsourcing engagements in the second
quarter of 1997. Information technology services revenue growth is due in part
to several large scale implementations of Windows NT in both the legal and
investment banking markets. The Company expects to continue to capitalize on the
marketplaces' migration from Netware to Windows NT.
The Company's strategy to focus on higher margin technology-related services
continues to drive a change in the Company's revenue mix, resulting in an
increase in technology services related revenues that typically generate a
higher margin. This change has resulted in a decline in the percentage of
Information Technology revenues associated with the resale of hardware or
software products, generally associated with a typical information technology
project. Product sales were 34% and 36% of total information technology revenues
for the three and six months ended June 30, 1997, as compared to 58% and 50% for
the three and six months ended June 30, 1996. The Company provides products to
its clients only as an accommodation and generally as required for particular
projects. The Company's maintenance contracts are priced on an annual basis with
payments generally made in advance. The Company's systems management contracts
are provided over multi-year terms, and invoiced on a monthly basis.
6
<PAGE>
DESI's cost of revenues associated with business services outsourcing are
comprised of wages, supplies, equipment, research and development and start-up
costs; its cost of revenues associated with systems management revenues are
comprised of wages, start-up costs and equipment; and its cost of revenues
associated with other information technology services are comprised of computer
equipment and software, labor costs, an overhead allocation and purchasing
expenses. The Company's gross profit margins on its information technology
services generally are higher than those associated with its business services
outsourcing. The Company's margins on resold products are lower than those for
business services outsourcing and information technology services.
DESI's selling expenses, included in selling, general and administrative
expenses, are comprised of sales and support salaries, commissions, travel and
entertainment. Selling expenses as a percentage of revenues for information
technology services are significantly higher than for business services
outsourcing due to the long-term nature of DESI's business services outsourcing
contracts.
DESI's research and development activities, included in selling, general and
administrative expenses, consist of software and hardware product evaluation,
trial integration of purchased hardware and software, user productivity
benchmarking and the development of custom integration software.
The Company's results of operations are sensitive to the state of the U.S.
professional service economy, particularly as it affects the Company's target
markets. The volume of services provided by the Company generally are lower in
periods in which activities of the Company's clients are reduced by economic or
other factors. The resulting decline in the Company's revenues from a particular
client affects the Company's net income because a large percentage of the
Company's costs are fixed, although this effect historically has been more than
offset by a growth in revenues from other clients. In addition, clients have
imposed pricing pressures on the Company during periods in which their
activities are reduced because of their own reduced levels of profitability,
thereby adversely affecting the Company's gross margins and results of
operations. Again, these pricing pressures have been offset by a growth in
revenues and the Company's ability to attract new clients who desire to reduce
their expenses by outsourcing certain services to the Company.
Initial Public Offering
On November 5, 1996, the Company completed an initial public offering of
2,860,000 shares of Common Stock (the "IPO"), 1,855,000 of which were sold by
the Company, and 1,005,000 of which were sold by R.R. Donnelley. Prior to the
IPO, the Company was a wholly-owned subsidiary of R.R. Donnelley. Of the $41.7
million of net proceeds to the Company from the IPO (1) approximately $8.7
million was used in final payment for certain contingent obligations arising
from the acquisition of LANSystems, Inc. (2) $20.3 million was used in repayment
of advances owed R.R. Donnelley, and (3) approximately $8.1 million was used in
repayment of the $8.0 million Dividend Note and accrued interest. The remaining
$4.6 million was used for general corporate purposes.
As a result of the IPO, the number of shares of common stock outstanding
increased to 5,005,000 shares (including 5,000 of restricted shares granted to a
key executive) from the 3,145,000 shares outstanding prior to the IPO and total
equity increased to approximately $50 million.
Relationship with R.R. Donnelley
Prior to the Offering, DESI operated as a separate business within R.R.
Donnelley. It had relied on R.R. Donnelley for its financing needs and for a
number of support services, including legal, tax, collections, insurance,
benefits administration, data processing and payroll. The Company has entered
into certain agreements pursuant to which R.R. Donnelley or its affiliates have
agreed to perform certain legal, tax, data processing, risk management, credit
and collection, cash management, banking and accounts payable services for the
Company. See Note 2 of Notes to the Consolidated Financial Statements. The
Company is charged fees and expenses for these services, but retains the right
to terminate certain services provided under the agreements upon 30 days notice.
As of June 30, 1997, the Company had advances payable to R.R. Donnelley
totaling approximately $2.9 million, which includes both the fees related to and
amounts funded by R.R. Donnelley on behalf of the Company as specified in the
transition services agreement.
7
<PAGE>
The consolidated 1996 financial statements reflect the results of operations,
financial position and cash flows of the Company on a carve-out basis; that is,
the financial statements have been adjusted to reflect certain expenses and
liabilities incurred by R.R. Donnelley on behalf of the Company. The Company
believes that the assumptions underlying all such adjustments are reasonable;
however, such consolidated financial statements do not necessarily reflect the
results of operations, financial position and cash flows of the Company had the
Company operated as a separate entity during the periods presented. Income taxes
reflected in such consolidated financial statements through the closing of the
IPO were determined as if the Company had filed a separate return.
Acquisition of LANSystems
LANSystems was acquired on June 21, 1995 for cash of approximately $16.6
million and certain contingent payment obligations. The acquisition was
accounted for as a purchase, with the excess of the purchase price over the fair
market value of net assets acquired being allocated to goodwill in the amount of
approximately $11.8 million. The goodwill is being amortized over its estimated
useful life of 20 years. LANSystems was acquired by R.R. Donnelley and, as such,
the Company was not required to provide cash for the acquisition. The earnout
provisions resulted in contingent payments in 1996 of $9.5 million to former
LANSystems shareholders and management participants. Payments made to the
recipients of the contingent payments have been treated as additional purchase
price for LANSystems, resulting in an increase in goodwill of approximately $9.5
million, which is being amortized over the remaining useful life (approximately
19 years).
Results of Operations
The following table sets forth certain items from the Company's unaudited
consolidated statements of income as a percentage of revenues for the periods
indicated:
<TABLE>
<CAPTION>
Three Months Six Months
Ended Ended
June 30, June 30,
-------------------------- --------------------------
1996 1997 1996 1997
------------ ------------ ----------- -------------
<S> <C> <C> <C> <C>
Revenues
Business services outsourcing 54.8% 59.9% 58.4% 60.2%
Information technology 45.2 40.1 41.6 39.8
----- ----- ----- -----
Total revenues 100.0 100.0 100.0 100.0
Cost of revenues 76.6 75.4 77.2 76.8
----- ----- ----- -----
Gross profit 23.4 24.6 22.8 23.2
Selling, general and administrative expenses 17.2 19.3 18.9 19.2
Amortization of goodwill .6 1.0 .7 1.0
----- ----- ----- -----
Earnings from operations 5.6 4.3 3.2 3.0
Interest expense 0.3 .2 .3 .1
----- ----- ----- -----
Earnings before income taxes 5.3 4.1 2.9 2.9
Income taxes 2.5 2.1 1.5 1.4
----- ----- ----- -----
Net income 2.8% 2.0% 1.4% 1.5%
===== ===== ===== =====
</TABLE>
Three months ended June 30, 1997 compared to three months ended June 30, 1996
Revenues for the three months ended June 30, 1997 totaled $28.7 million, an
increase of 15.9% over 1996 revenues for the same period of $24.8 million. This
$3.9 million increase was comprised of a $3.6 million, or 26.5%, increase in
business services outsourcing revenues and a $.3 million increase, or 3%,
increase in information technology services revenue. Business services
outsourcing revenue growth was due to a $2.7 million increase in revenues from
new clients and a $.9 million increase in revenues from existing clients.
During the three months ended June 30, 1997, the Company's cost of revenues of
$21.7 million decreased as a percentage of revenues from 76.6% for the three
months ended June 30, 1996 to 75.4% in 1997. This decrease occurred as a
result of an increase in the business services outsourcing margins, offset
by a decrease in information technology services margins. Business services
outsourcing margins increased as a result of increased revenues in the
higher margin
8
<PAGE>
services of imaging and networked color printing. Information technology
services margins decreased primarily as a result of the impact of hiring new
engineers, some of whom were not billable through part of the three months ended
June 30, 1997.
Selling, general and administrative expenses increased $1.3 million, or 30.1%,
for the three months ended June 30, 1997 and as a percentage of revenues,
increased to 19.3% in the second quarter of 1997 from 17.2% in 1996. The
increase in selling, general and administrative expenses for the three months
ended June 30, 1997 was primarily due to increased investment in administrative
systems necessary to operate as an independent public company. These
investments, which are substantially complete, have been made in a new financial
system, a common technology platform and in the consolidation of the accounting
function. These investments are expected to be fully completed by the end of
the year.
During the three months ended June 30, 1997, amortization of goodwill
increased 69.0% to $267,000, compared to the corresponding period in 1996. This
increase is due to additional goodwill recorded for certain contingent
obligations arising from the acquisition of LANSystems.
The Company's effective income tax rate increased to 50.4% in the three months
ending June 30, 1997 from 47.5% in 1996. The effective tax rate exceeds the U.S.
federal statutory rate primarily due to the effect of nondeductible goodwill
amortization and state taxes.
Net income decreased $0.1 million to $0.6 million in the second quarter of
1997 compared to the second quarter of 1996 as a result of the foregoing
factors.
Six months ended June 30, 1997 compared to six months ended June 30, 1996
Revenues for the six months ended June 30, 1997 totaled $55.8 million, an
increase of 23.3% over 1996 revenues for the same period of $45.2 million. This
$10.5 million increase was comprised of a $7.1 million, or 27.0%, increase in
business services outsourcing revenues and a $3.4 million, or 18.1%, increase
attributable to information technology services. Business services outsourcing
growth was due to a $5.1 million increase in revenues from new clients and a
$2.0 million increase in revenues from existing clients. Information technology
services growth of $3.4 million was due to a $2.1 million increase from systems
management and a $1.3 million increase from LANSystems. Systems management
growth of $2.1 million was due to a $1.8 million increase in revenues from new
clients and a $.3 million increase in revenues from existing clients.
For the six months ended June 30, 1997, the Company's cost of revenues of
$42.8 million decreased as a percentage of revenues from 77.2% for the six
months ended June 30, 1996 to 76.8% in 1997. This decrease occurred because of
an increase in the business services outsourcing margins, offset by a decrease
in the information technology services margins. Business services outsourcing
margins increased as a result of increased revenues in the higher margin
services of imaging and networked color printing. Information technology
services margins decreased primarily as a result of the impact of hiring new
engineers, most of whom were not billable through part of the six months ended
June 30, 1997.
Selling, general and administrative expenses increased $2.2 million for the
six months ended June 30, 1997 from the same period in 1996, and as a percentage
of revenue to 19.2% from 18.9% in 1996. The increase in selling, general and
administrative expenses for the six months ended June 30, 1997 was primarily due
to increased investment in administrative systems necessary to operate as an
independent public company. These investments, which are substantially complete,
have been made in a new financial system, a common technology platform and the
consolidation of the accounting function. These investments are expected to be
fully completed by the end of the year.
During the six months ended June 30, 1997, amortization of goodwill increased
73.9% to $532,000, compared to the corresponding period in 1996. This increase
is due to additional goodwill recorded for certain contingent obligations
arising from the acquisition of LANSystems.
The Company's effective income tax rate decreased to 50% in the first six
months of 1997 from 53.4% in 1996. The effective tax rate exceeds the U.S.
federal statutory rate primarily due to the effect of nondeductible goodwill
amortization and state taxes.
Net income increased $0.2 million to $0.8 million for the six months ended
June 30, 1997 compared to the six months ended June 30, 1996 as a result of the
foregoing factors.
Liquidity and Capital Resources
9
<PAGE>
Prior to the completion of the IPO, the Company funded its operations, capital
expenditures and acquisitions through cash flows from operations, amounts
advanced interest-free from R.R. Donnelley and the sale of its business services
outsourcing accounts receivable to a subsidiary of R.R. Donnelley. These
receivables were sold without recourse and the Company was not charged any
factoring cost. The arrangement pursuant to which the Company sold such
receivables to a subsidiary of R.R. Donnelley was terminated on December 16,
1996.
On November 6, 1996, the Company entered into a credit agreement (the "Credit
Agreement") with Harris Trust and Savings Bank (the "Bank") under which it is
entitled to borrow up to $22.0 million on a revolving credit basis. Borrowings
under the Credit Agreement will mature in three years and will bear interest (i)
at the prime rate announced by the Bank or (ii) at the applicable LIBOR rate
plus, depending on the Company's fixed charge coverage ratio, up to 125 basis
points per annum. In addition, the Company will pay a commitment fee of 20 to 30
basis points per annum, depending on its fixed charge coverage ratio. The Credit
Agreement contains customary financial and other covenants, including
requirements to maintain a minimum consolidated net worth, a minimum fixed
charge coverage ratio and a maximum leverage ratio, and restrictions on liens,
investments, dividends, indebtedness, acquisitions and transactions with
affiliates. The Company has historically not paid interest with respect to the
advances it received from R.R. Donnelley. The Company's interest expense will
increase as the Company borrows under the Credit Agreement. At June 30, 1997,
the Company was in compliance with all debt covenants and there were $12.0
million in borrowings outstanding under the Credit Agreement.
The Company had net usage of cash from operations of $8.9 million during the
six months ended June 30, 1997, as compared to cash used by operations of $9.1
million in 1996. The decreased usage in 1997 was primarily due to an increase in
net income and depreciation offset by a decrease in the net change in assets and
liabilities. The decrease in the net change in assets and liabilities was
primarily due to improved management of inventories and payables as well as an
increase in deferred revenues more than offset by an increase in receivables of
$11.2 million. This increase is due to a number of factors, including the
termination of the factoring arrangement with R.R. Donnelley and delays in
billing and collection functions at LANSystems. These LANSystems functions were
delayed because of the implementation of new systems at LANSystems, the
implementation of the Company's new financial management and accounting system,
and the centralization of the Company's accounting function. The Company
anticipates that days outstanding in receivables will decrease in the third and
fourth quarters of 1997.
Capital expenditures increased $2.3 million to $4.4 million in the first six
months of 1997 from $2.1 million in 1996, primarily due to new client site
start-ups and investment in the Company's financial and operating management
system that is being implemented. For the six months ended June 30, 1997, the
Company had $7.9 million of cash provided by financing activities, primarily
from the Credit Agreement offset by a reduction in Advances from Related Party.
For the six months ended June 30, 1997 operating cash flow (earnings from
operations plus depreciation and amortization) was $4.8 million, up from $3.8
million for the corresponding period in 1996. The Company believes cash flows
from operations and the Credit Agreement will be sufficient to fund, during the
term of the Credit Agreement, its ongoing operations, continued growth and
investment, including acquisitions.
10
<PAGE>
PART II--OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
The Company's Annual Meeting of Stockholders was held on May 7, 1997. The
matters voted upon at the Annual Meeting were:
1. Election of Directors
Charles F. Moran [4,306,419] For
[ 12,151] Against
[ 0] Withheld Authority
[ 0] Broker Non-Votes
Daniel I. Malina [4,306,419] For
[ 12,151] Against
[ 0] Withheld Authority
[ 0] Broker Non-Votes
2. Approval of the [4,020,900] For
Donnelley Enterprise [ 23,101] Against
Solutions Incorporated [ 2,310] Abstentions
1997 Non-Employee [ 272,259] Broker Non-Votes
Director Stock Plan
3. Approval of the Amended [4,008,190] For
and Restated Donnelley [ 17,701] Against
Enterprise Solutions [ 2,300] Abstentions
Incorporated 1996 [ 290,379] Broker Non-Votes
Stock Incentive Plan
4. Approval of the [4,030,860] For
Donnelley Enterprise [ 13,351] Against
Solutions Incorporated [ 2,100] Abstentions
1997 Employee Stock [ 272,259] Broker Non-Votes
Purchase Plan
Item 5. Other Information
Safe Harbor Statement Under the Private Securities Litigation Reform Act of
1995. Certain statements in this filing and elsewhere (such as in other filings
by the Company with the Securities and Exchange Commission, press releases,
presentations by the Company or its management and oral statements) may
constitute "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. Specifically, the words "intends,"
"expects," "plans," "anticipates," "estimates," and similar expressions are
intended to identify forward-looking statements. Such forward-looking statements
involve known and unknown risks, uncertainties, and other factors which may
cause the actual results, performance or achievements of the Company to be
materially different from future results, performance or achievements expressed
or implied by such forward-looking statements. Such factors include: (i)
dependence on Key clients; (ii) dependence on ability to manage growth; (iii)
sensitivity to fluctuations in professional service economy; (iv) risks
associated with performance of information technology projects; (v) focus on
limited target markets; (vi) ability to grow through introduction of new
services; (vii) dependence on ability to anticipate technological advances;
(viii) risks associated with integration of LANSystems and growth through future
acquisitions; (ix) variability of quarterly results; (x) need to attract and
retain key personnel in highly competitive market place; (xi) dependence on
senior management; (xii) lack of operating history as a stand-alone entity;
Refer to Part II, Item 7, of the Company's Annual Report on Form 10-K for the
year ended December 31, 1996 and the Company's Registration Statement (No. 333-
10127) under "Risk Factors" for a more detailed description of such factors.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
3.1 First Amended and Restated Certificate of Incorporation of the
Company.(1)
3.2 By-laws of the Company.(1)
10.1 Transition Services Agreement between the Company and
R.R. Donnelley.(1)
10.2 Benefit Administration Services Agreement between the Company and
R.R. Donnelley.(1)
10.3 Tax Allocation and Indemnification Agreement between the Company
and R.R. Donnelley.(1)
10.4 Employment Agreement between Rhonda I. Kochlefl and the
Company.(1)(2)
10.5 Employment Agreement between Leo S. Spiegel and the Company.(1)(2)
10.6 Employment Agreement between Luke F. Botica and the Company.(2)(3)
10.7 Employment Agreement between Linda A. Finkel and the Company.(2)(3)
10.8 Severance Agreement between Thomas P. Bradbury and the
Company.(1)(2)
10.9 1996 Broad-Based Employee Stock Plan.(1)(2)
10.10 Agreement of Merger among R.R. Donnelley & Sons Company, Donnelley
DBS, Inc. and LANSystems, Inc.(1)
10.11 Form of Credit Agreement among the Company, as Borrower, and the
Banks named therein.(1)
10.12 1997 Non-Employee Director Stock Plan.(2)(3)
10.13 Amended and Restated 1996 Stock Incentive Plan.(2)(3)
10.14 1997 Employee Stock Purchase Plan. (3)
10.15 Employment Agreement between David A. Shea and the Company.(2)
10.16 Employment Agreement between Robert A. Lento and the Company.(2)
27.1 Financial Data Schedule.
______________
(1) Incorporated herein by reference to the Company's Registration Statement on
Form S-1 (No. 333-10127), declared effective on October 30, 1996.
(2) Indicates a management contract or compensatory plan or agreement.
(3) Incorporated herein by reference to the Company's 1996 Annual Report on
Form 10-K.
(b) No Current Report on Form 8-K was filed by the Company during the second
quarter of 1997.
<PAGE>
SIGNATURE
Pursuant to the requirement 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.
Donnelley Enterprise Solutions Incorporated
By: /s/ Luke F. Botica
------------------------------------------------
Luke F. Botica
Senior Vice President & Chief Financial Officer
(Principal Financial Officer)
Date: August 14, 1997
By: /s/ Thomas A. Munro
------------------------------------------------
Thomas A. Munro
Vice President & Corporate Controller
(Principal Accounting Officer)
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