<PAGE>
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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
Commission File Number 0-21525
Donnelley Enterprise Solutions Incorporated
(Exact name of registrant as specified in its charter)
Delaware 13-3160717
(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
November 14, 1997.
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INDEX
<TABLE>
<CAPTION>
Page
----
Part I--Financial Information
Item 1. Financial Statements
<S> <C> <C>
Consolidated Statements of Income for the three and nine month periods ended
September 30, 1996 and 1997............................................................ 1
Consolidated Balance Sheets as of December 31, 1996 and September 30, 1997.............. 2
Consolidated Statements of Cash Flows for the nine month periods ended September 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................................ *
Item 5. Other Information.................................................................. 14
Item 6. Exhibits and Reports on Form 8-K................................................... 14
__________
*No response to this item is included herein for the reason that it is inapplicable or the
answer to such item is negative.
</TABLE>
<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 Nine Months Ended
September 30, September 30,
------------- -------------
1996 1997 1996 1997
---- ---- ---- ----
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
Business services outsourcing revenues.............. $14,733 $ 16,987 $ 41,164 $ 50,544
Integration services revenues....................... 10,800 6,510 29,406 26,238
Systems management outsourcing revenues............. 247 2,012 453 4,492
------- -------- ------- --------
Total revenues.................................... 25,780 25,509 71,023 81,274
Cost of revenues.................................... 20,049 21,919 54,957 64,720
------- -------- ------- --------
Gross profit...................................... 5,731 3,590 16,066 16,554
Selling, general and administrative expenses........ 4,066 9,230 12,635 19,963
Amortization of goodwill............................ 229 270 534 802
Special Charge...................................... 300 --- 300 --
------- -------- ------- --------
Earnings from operations....................... 1,136 (5,910) 2,597 (4,211)
Interest expense.................................... 187 235 313 307
------- -------- ------- --------
Earnings before income taxes................... 949 (6,145) 2,284 (4,518)
Income taxes........................................ 475 (1,923) 1,188 (1,109)
------- -------- ------- --------
Net income..................................... 474 (4,222) 1,096 (3,409)
======= ======== ======= ========
Earnings per share.................................. (.84) (.68)
======== ========
Common shares outstanding........................... 5,005,000 5,005,000
========= =========
Pro forma earnings per share........................ .09 .22
=== ===
Pro forma common shares outstanding................. 5,005,000 5,005,000
========= =========
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
1
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DONNELLEY ENTERPRISE SOLUTIONS INCORPORATED
CONSOLIDATED BALANCE SHEETS
($000s, except per share data)
<TABLE>
<CAPTION>
ASSETS December 31, September 30,
------ 1996 1997
---- ----
(Unaudited)
Current assets:
<S> <C> <C>
Cash and equivalents...................................................... $ 8,910 $ 705
Accounts receivable, less allowances for doubtful
accounts of $460 in 1996 and $3,943 in 1997............................... 21,228 21,283
Unbilled receivables, less allowances for doubtful
accounts of $0 in 1996 and $200 in 1997................................... 4,847 12,501
Inventories............................................................... 4,144 3,588
Prepaid expenses and other current assets................................. 1,728 1,051
Income taxes receivable................................................... 1,533 2,454
Deferred income taxes..................................................... 867 2,383
------- -------
Total current assets...................................................... 43,257 43,965
Property and equipment, net.................................................... 12,646 15,569
Goodwill, net.................................................................. 20,213 19,428
Other noncurrent assets........................................................ 60 56
------- -------
Total assets.............................................................. $76,176 $79,018
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Line of credit............................................................ $ -- $10,000
Capital lease obligations, current........................................ 1,162 1,069
Notes payable, current.................................................... -- 111
Advances due to related party............................................. 6,455 2,465
Accounts payable.......................................................... 7,633 9,274
Accrued salary and benefits............................................... 2,280 3,287
Accrued other expenses.................................................... 2,010 1,526
Customer prepayments...................................................... 4,434 --
Deferred revenues......................................................... 1,134 3,495
------- -------
Total current liabilities.............................................. 25,108 31,227
Noncurrent liabilities:
Capital lease obligations................................................. 1,305 1,408
Deferred income taxes..................................................... 311 387
Notes payable............................................................. -- 102
------- -------
Total noncurrent liabilities........................................... 1,616 1,897
Shareholders' equity:
Common stock--$.01 par value, 15,000,000 authorized shares; 5,005,000
issued and outstanding at December 31, 1996 and September 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
Cumulative translation adjustment......................................... -- 5
Retained earnings......................................................... 3 (3,406)
------- -------
Total shareholders' equity............................................. 49,452 45,894
------- -------
Total liabilities and shareholders' equity............................. $76,176 $79,018
======= =======
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
2
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DONNELLEY ENTERPRISE SOLUTIONS INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
($000s)
<TABLE>
<CAPTION>
Nine months ended September 30
1996 1997
---- ----
Cash flows provided by (used in) operating activities: (Unaudited)
<S> <C> <C>
Net income.......................................................... $ 1,096 $(3,409)
Depreciation and amortization....................................... 3,301 3,977
Amortization of goodwill............................................ 534 802
Gain on sales of equipment.......................................... -- (234)
Net changes in assets and liabilities............................... (15,019) (8,759)
-------- -------
Net cash used in operating activities.......................... (10,088) (7,623)
-------- -------
Cash flows (used in) provided by investing activities:
Capital expenditures................................................ (4,095) (6,044)
LANSystems contingent payments...................................... (9,494) --
Net proceeds on sales of equipment.................................. -- 337
-------- -------
Net cash used in investing activities.......................... (13,589) (5,707)
-------- -------
Cash flows (used in) provided by financing activities:
Advances from (to) related parties, net............................. 24,449 (3,990)
Repayments/dividends to related party............................... (8,622) --
Due LANSystems earnout participants................................. 8,700 --
Line of credit...................................................... -- 10,000
Notes payable....................................................... -- 213
Principal payments on capital leases................................ (951) (949)
Stock issuance costs................................................ -- (149)
-------- -------
Net cash provided by financing activities...................... 23,576 5,125
-------- -------
Net decrease in cash and equivalents................................ (101) (8,205)
Cash and equivalents, at beginning of period................... 652 8,910
Cash and equivalents, at end of period......................... 551 705
======== =======
The changes in assets and liabilities were as follows:
Decrease (increase) in assets:
Receivables, net............................................... $ (8,659) $(7,709)
Inventories.................................................... (1,091) 556
Prepaid expenses and other..................................... (846) 677
Income taxes receivable........................................ (40) (921)
Deferred income taxes.......................................... 88 (1,516)
Other noncurrent assets........................................ (2) (13)
Increase (decrease) in liabilities:
Accounts payable............................................... (224) 1,641
Accrued salary and benefits.................................... (111) 1,007
Accrued other expenses......................................... (499) (484)
Customer prepayments........................................... (2,996) (4,434)
Deferred income taxes.......................................... -- 76
Deferred revenues.............................................. (386) 2,361
Other noncurrent liabilities................................... (253) --
-------- -------
Net change in assets and liabilities.................................... $(15,019) $(8,759)
======== =======
Cash paid for:
Interest............................................................ 313 333
Income taxes........................................................ $ 246 $ 1,250
======== =======
Supplemental non-cash investing and financing activities:
Capital leases........................................................ $ 187 $ 959
======== =======
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
3
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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 three general categories of services: business
services outsourcing, integration services and systems management outsourcing.
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 integration
services ("LANSystems") offerings include systems integration, consulting,
training and software development. Systems management outsourcing offerings
include on-site management and administration of servers and desktops including
the operation of client help desk functions.
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 for the period prior to the IPO 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
4
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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. As of
September 30, 1997, R.R. Donnelley was only providing tax services for the
Company. The Company is charged fees and expenses for these services and will
be terminating these services as of November 30, 1997.
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 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 nine
months ended September 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 effective November 6, 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. The agreement was amended on
September 30, 1997.
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.
Note 7. Change in Estimate
In the third quarter of 1997, the Company recorded two significant changes
in estimate. One change in estimate affected revenue and gross profit by $3.3
million and $2.3 million, respectively, for a change in estimate in integration
services at LANSystems resulting from the reduction in scope on certain
integration
5
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projects, operating performance issues and an increase in the estimated number
of hours required to complete certain other projects. The second change in
estimate affected the allowance for doubtful accounts in the amount of $3.6
million, which was primarily due to the increased age of the receivables at
LANSystems which lessens the likelihood of collection. The increased age of the
receivables was primarily due to the implementation of a new system and employee
turnover.
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 grown 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 September 30, 1997, the
Company's revenues from business services outsourcing, integration services and
systems management outsourcing were $17.0 million, $6.5 million and $2.0
million, respectively, compared to $14.7 million for business services
outsourcing, $10.8 million for integration services and $.2 million for systems
management outsourcing for the same period of 1996. In the nine months ended
September 30, 1997, the Company's revenues from business services outsourcing,
integration services and systems management outsourcing were $50.5 million,
$26.2 million and $4.5 million, respectively, compared to $41.2 million for
business services outsourcing, $29.4 million for integration services and $.5
million for systems management 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 information
technology 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 and (vi) technical
training projects. 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
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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. The Company typically enters into systems
management contracts with terms that average three years. System management
contracts are priced on a monthly fixed fee basis, plus a fee for overtime and
additional services. Integration services contracts are priced on a fixed-fee
basis or a time-and-materials basis. Contracts for integration services projects
typically include scope of work and acceptance criteria for identifying project
completion. The Company typically seeks to obtain an increase in its fixed 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 third
quarter of 1997. Integration services revenue projects include 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.
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 integration services are comprised of computer equipment,
software and labor costs. The Company's gross profit margin on systems
management outsourcing is higher than those associated with its business
services outsourcing and integration services. The Company's margin on resold
products within integration services are lower than those for business services
outsourcing and systems management outsourcing. Integration service margins tend
to fluctuate more than business services outsourcing margins and systems
management outsourcing margins.
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 integration
services are significantly higher than for business services outsourcing and
systems management 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
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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 and focus on their core business 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.
8
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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. As of September 30, 1997, R.R. Donnelley was only providing tax
services for the Company. The Company is charged fees and expenses for these
services and will be terminating these services as of November 30, 1997.
As of September 30, 1997, the Company had advances payable to R.R.
Donnelley totaling approximately $2.5 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.
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).
9
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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 Nine Months
Ended Ended
September 30, September 30,
------------- -------------
1996 1997 1996 1997
---- ----- ---- ----
<S> <C> <C> <C> <C>
Revenues
Business services outsourcing
57.1% 66.6% 58.0% 62.2%
Integration services 41.9 25.5 41.4 32.3
Systems management outsourcing 1.0 7.9 .6 5.5
----- ----- ----- -----
Total revenues 100.0 100.0 100.0 100.0
Cost of revenues 77.8 85.9 77.4 79.6
----- ----- ----- -----
Gross profit 22.2 14.1 22.6 20.4
Selling, general and administrative
expenses 15.8 36.2 17.8 24.6
Amortization of goodwill .9 1.1 .8 1.0
Special charge 1.2 -- .4 --
----- ----- ----- -----
Earnings from operations 4.3 (23.2) 3.6 (5.2)
Interest expense 0.7 .9 .4 .4
----- ----- ----- -----
Earnings before income taxes 3.6 (24.1) 3.2 (5.6)
Income taxes 1.8 (7.5) 1.7 (1.4)
----- ----- ----- -----
Net income 1.8% (16.6)% 1.5% (4.2)%
===== ===== ===== =====
</TABLE>
Three months ended September 30, 1997 compared to three months ended September
30, 1996
Revenues for the three months ended September 30, 1997 totaled $25.5
million, a decrease of 1.1% over 1996 revenues for the same period of $25.8
million. This $.3 million decrease was comprised of a $2.2 million, or 15.3%,
increase in business services outsourcing revenues, a $4.3 million, or 39.7%,
decrease in integration services revenues and a $1.8 million, or 714.6%,
increase attributable to systems management outsourcing revenues. The
integration services revenue decrease was due to a $3.3 million change in
estimate resulting from the reduction in scope on certain integration projects,
operating performance issues and an increase in the estimated hours required to
complete certain other projects as well as a $1.0 million decrease due to
reduced sales with new and existing customers. Systems management outsourcing
revenues increased by $1.8 million as a result of eight new contracts with six
customers. Business services outsourcing revenue growth was due to a $1.6
million increase in revenues from new
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clients and a $.6 million increase in revenues from existing clients.
During the three months ended September 30, 1997, the Company's cost of
revenues of $21.9 million increased as a percentage of revenues from 77.8% for
the three months ended September 30, 1996 to 85.9% in 1997. This increase
occurred due to a decrease in margins in integration services at LANSystems
primarily as a result of the change in estimate resulting from the reduction in
scope on certain integration projects, operating performance issues and an
increase in the estimated hours required to complete certain other projects as
well as by an increase in the reserve for obsolete inventory in the amount of
$250,000. In addition, systems management outsourcing margins decreased due to
start-up costs. These decreases were offset in part by an increase in business
services outsourcing margins, which increased as a result of increased revenues
in the higher margin services of imaging, networked color printing and desktop
publishing.
Selling, general and administrative expenses increased $5.2 million, or
127.0%, for the three months ended September 30, 1997 and as a percentage of
revenues, increased to 36.2% in the third quarter of 1997 from 15.8% in 1996.
The increase in selling, general and administrative expenses for the three
months ended September 30, 1997 was primarily due to an increase in the
allowance for doubtful accounts of $3.6 million due to the increased age of
receivables, which lessens the likelihood of collection. The increased age of
the receivables was primarily due to the implementation of a new system and
employee turnover. The increase was also 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 and a common technology platform.
During the three months ended September 30, 1997, amortization of goodwill
increased 17.9% to $270,000, 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 from a provision of 50.0%
in the three months ended September 30, 1996 to a tax benefit of 31.3% in the
three months ending September 30, 1997, primarily due to a taxable loss for the
third quarter of 1997.
Net income decreased $4.7 million to a net loss of $4.2 million in the
third quarter of 1997 compared to the third quarter of 1996 as a result of the
foregoing factors.
Nine months ended September 30, 1997 compared to nine months ended September 30,
1996
Revenues for the nine months ended September 30, 1997 totaled $81.3
million, an increase of 14.4% over 1996 revenues for the same period of $71.0
million. This $10.3 million increase was comprised of a $9.4 million, or 22.8%,
increase in business services outsourcing revenues, a $3.1 million, or 10.8%,
decrease in integration services revenues and a $4.0 million, or 891.6%,
increase in systems management outsourcing revenues. Business services
outsourcing growth was due to a $6.8 million increase in revenues from new
clients and a $2.6 million increase in revenues from existing clients. Systems
management outsourcing growth of $4.0 million was due to a $3.9 million increase
in revenues from new clients and a $.1 million increase in revenues from
existing clients. The integration services revenue decrease of $3.1 million was
due to the change in estimate resulting from the reduction in scope on certain
integration projects, operating performance issues and an increase in the
estimated hours required to complete certain other projects.
For the nine months ended September 30, 1997, the Company's cost of
revenues of $64.7 million increased as a percentage of revenues to 79.6% for the
nine months ended September 30, 1997 from 77.4% in 1996. This increase occurred
because of a decrease in integration services margins and systems management
outsourcing margins offset by an increase in the business services outsourcing
margins. Integration services margins decreased primarily due to the change in
estimate recorded and an increase in the reserve for obsolete inventory in the
amount of $250,000 at LANSystems while systems management outsourcing margins
decreased due to start-up costs at new customers. Business services outsourcing
margins increased as a result of increased revenues in the higher margin
services of imaging, networked color printing and desktop publishing.
11
<PAGE>
Selling, general and administrative expenses increased $7.3 million for the
nine months ended September 30, 1997 from the same period in 1996, and as a
percentage of revenue to 24.6% from 17.8% in 1996. The increase in selling,
general and administrative expenses for the nine months ended September 30, 1997
was primarily due to an increase in the allowance for doubtful accounts of $3.6
million primarily due to the increased age of receivables, which lessens the
likelihood of collection. The increased age of the receivables was primarily due
to the implementation of a new system and employee turnover. The increase was
also 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 and a common technology
platform.
During the nine months ended September 30, 1997, amortization of goodwill
increased 50.2% to $802,000, 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 from a provision of 52.0%
for the nine months ended September 30, 1996 to a tax benefit of 24.5% for the
nine months ended September 30, 1997, primarily due to a taxable loss in the
third quarter of 1997.
Net income decreased $4.5 million to a net loss of $3.4 million for the
nine months ended September 30, 1997 compared to the nine months ended September
30, 1996 as a result of the foregoing factors.
Liquidity and Capital Resources
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 with 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 September 30,
1997, the Company was in compliance with all covenants and there were $10.0
million in borrowings outstanding under the Credit Agreement.
The Company had net usage of cash from operations of $7.6 million during
the nine months ended September 30, 1997, as compared to cash used by operations
of $10.1 million in 1996. The decreased usage in 1997 was primarily due to an
increase in the net change in assets and liabilities and an increase in
depreciation offset by a decrease in net income. The increase 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 offset by
increases in income tax receivables, deferred income tax assets and customer
prepayments.
Capital expenditures increased $1.9 million to $6.0 million in the first
nine months of 1997 from $4.1 million in 1996, primarily due to new client site
start-ups and investment in the Company's financial and operating management
system that has been substantially implemented. For the nine months ended
September 30, 1997, the Company had
12
<PAGE>
$5.1 million of cash provided by financing activities, primarily from the Credit
Agreement offset by a reduction in Advances from Related Party.
For the nine months ended September 30, 1997 operating cash flow (earnings
from operations plus depreciation and amortization) was $.6 million, down from
$6.4 million for the corresponding period in 1996. This decrease was due to the
changes in estimate taken in the third quarter of 1997 offset by an increase in
operating cash flow in business services outsourcing of $2.2 million and systems
management outsourcing of $1.1 million. 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 and continued growth and
investment, including acquisitions.
13
<PAGE>
PART II--OTHER INFORMATION
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)
20.1 Resignation of Luke Botica, the Company's Senior Vice President, Chief
Financial Officer and Treasurer
20.2 One-time charge in the Company's integration division
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.
14
<PAGE>
(3) Incorporated herein by reference to the Company's 1996 Annual Report on
Form 10-K.
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
Date: November 14, 1997 By: /s/ Thomas A. Munro
---------------------------------------
Thomas A. Munro
Vice President & Corporate Controller
(Principal Accounting Officer)
15
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