<PAGE>
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended May 31, 1997
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________ to _________
Commission file number: 0-08718
CITADEL COMPUTER SYSTEMS INCORPORATED
(Exact name of small business issuer
as specified in its charter)
DELAWARE 75-2432011
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3811 TURTLE CREEK BLVD., SUITE 600, DALLAS, TX 75219
(Address of principal executive offices)
(214) 520-9292
(Issuer's telephone number)
----------
(Former name, former address and former fiscal year, if changed since last
report)
Check whether the issuer (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for
such shorter period 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 _____
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date.
Common Stock, par value $.01
18,536,902
- ---------------------------
Outstanding at October 14, 1997
Transitional Small Business Disclosure Format Yes [ ] No [X]
1
<PAGE>
UNLESS OTHERWISE INDICATED, SHARE AND PER SHARE INFORMATION CONTAINED IN THIS
REPORT REFLECT THE COMPANY'S ONE-FOR-TWO REVERSE STOCK SPLIT, EFFECTIVE AS OF
MAY 1, 1996.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
The Financial Statements of the Company are found after the signature page
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
The statements contained in this Report that are not historical facts,
including, but not limited to, statements found in this Item 2 -
"Management's Discussion and Analysis," are forward looking statements and as
such involve a number of risks and uncertainties. The actual results of the
future events described in such forward-looking statements in this Report
could differ materially from those stated in such forward looking statements.
Among the factors that could cause actual results to differ materially are:
general economic conditions; competition; the market for network software
products; seasonality of product sales; the Company's Capital requirements
and the uncertainty of additional funding; the Company's inconsistent
revenues and the uncertainty of future profitability; costs and risks related to
integration of acquisitions; uncertainties related to new product development
and market acceptance of new products; costs, expenses and delays in
sales related to the implementation of new sales methods; software
development costs; litigation; as well as the risks and uncertainties
discussed in this Report, including, without limitation, the portions
referenced above, and the uncertainties set forth from time to time in the
Company's other public reports and filings and public statements.
RESULTS OF OPERATIONS
During the three months ended May 31, 1997, the Company had net sales of
$492,274, a decrease of $632,137, or 56.2% over net sales of $1,124,411
during the three months ended May 31, 1996.
During the quarter the Company was integrally involved with completing
its corporate plan of restructuring, which included the consolidation of its
Houston operations into its Dallas location; the elimination of outside
sales offices; the outsourcing of certain functions previously performed
in-house; the reduction of its workforce by approximately 70%; the
identification of areas for greater operational efficiencies to enable the
Company to significantly reduce its overhead and administrative expenses; and
development and implementation of new sales and marketing strategies. The
new sales and marketing strategies focus the Company's efforts more toward
the traditional VAR, reseller, OEM and joint venture model and less towards
the Company's historical telemarketing and trade-show model. While the
Company believes these changes attributed to its sales decrease during the
quarter and believes that sales will continue to be below last years numbers
through the second and third quarters. The Company believes that the newly
adopted strategies will better position the Company for the future and
anticipates that these strategies will result in increased sales in the
future.
The Company during the past six months has entered into a agreement with
Microsoft relating to its Winshield product and has recently entered into a
strategic alliance with Compaq Computer, whereby the Company's Winshield
product will be bundled as part of the software offered on certain Presario
computers shipped by Compaq to the educational market. In October 1997, the
Company entered into a strategic alliance with CORESTAFF with respect to
CORESTAFF's investment in the Company and certain joint research and
development, technology, licensing and marketing activities. The Company is
continuing to explore similar arrangements with other market leaders in the
technology industry and expects to finalize additional alliances in its third
and fourth quarters. The Company expects this channel to represent a
significant percentage of the Company's revenue in the future.
In addition, the Company has recently started to market its products
internationally, and while delays in specific country localization of its
products have resulted in anticipated sales being delayed into future
quarters, the Company's products are being extremely well received
internationally and the Company expects this channel also to represent a
significant percentage of its revenues in the future.
2
<PAGE>
The Company has recently introduced its IOMEGA endorsed C:\MORE! product
and expects to launch its Network Recovery System product in the third
quarter of fiscal 1998. The Company is also beta testing a Windows 95 32-bit
upgrade to its Winshield product and expects to launch additional new
products and upgrades in future quarters of fiscal 1998 that will provide
ease of use security for Internet and intranet applications on Microsoft and
Novell platforms.
The costs and expenses incurred in connection with producing the
Company's products were $9,411 during the quarter, a decrease of $37,461 or
80% over cost of sales of $46,872 for the same period last year. As a
percentage of sales, the Company's cost of sales for the quarter decreased
from 4.2% for the three months ended May 31, 1996 to 1.9% for the three
months ended May 31, 1997. This resulted primarily from the company bringing
its order fulfillment in-house versus out-sourcing this service as it had
done in the past. The Company, as part of its restructuring, has recently
started to out-source a significant portion of its order fulfillment.
Therefore, the Company would expect that these expenses may increase, as a
percentage of sales, in future periods. However, as an increasing percentage
of the Company's sales are sold through strategic alliances, electronic
commerce, site licensing, etc., the actual impact on the Company's operating
performance is expected to be minimal.
Selling, general and administrative expenses for the three months ended
May 31, 1997, were $1,003,695, a decrease of $437,378, or 30.4%, over
selling, general and administrative expenses of $1,441,073 during the three
months ended May 31, 1996. Such expenses decreased primarily due to the
Company's savings as a result of its reorganization, a decrease in its
provision for sales returns and allowance for doubtful accounts and a
decrease in the Company's trade-show activities as a result of the change in
the Company's sales approach, as discussed earlier. These decreases were
offset by start-up and marketing expenses associated with its new sales
approach and new product introductions; expenses related to its status as a
publicly traded company; and its continued efforts to expand its product
offerings. The Company expects as revenues increase, it will allocate
additional resources to selling and marketing activities, thus these expenses
may be expected to increase in future periods.
Research and development costs charged to expense for the quarter were
approximately $38,296 versus $48,723 for the same period last year, or a
decrease of $10,427 or 21.4%. As a result of the development activity on two
of the Company's new products, which will be introduced during the second and
third quarters of this year, approximately $146,000 of research and
development costs were capitalized during the quarter versus approximately
$70,000 for the same quarter last year. The Company expects to launch
additional new products and upgrades in the future quarters of fiscal 1998
that will provide for ease of security solutions for Internet and intranet
applications on Microsoft and Novell platforms.
Depreciation and amortization expense increased $109,524, or 66.5% to
$274,172 from $164,648 for the three months ended May 31, 1997 and 1996,
respectively. This increase resulted from depreciation and amortization of
certain acquisitions and products in this quarter that were not present in
the previous year's quarter and the commencement of amortization on certain
capitalized research and development costs relating to products that are
available for sale.
Interest expense for the three months ended May 31, 1997 decreased to
$21,226 a decrease of $13,426 or 38.7%, over interest expense of $34,652
during the same period last year.
3
<PAGE>
During the three months ended May 31, 1996, the Company determined that
it could no longer recover the value of certain stock and wrote the
investment down by taking a charge to earnings of $1,000,000 (for further
discussion on this write-down reference is made to ITEM 5 - OTHER INFORMATION
of this report).
As a result of the aforementioned the Company, for the three months ended
May 31, 1997, reported a net loss of $861,119, compared to a net loss of
approximately $1,611,557 for the same period last year.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash and cash equivalents at May 31, 1997 were $37,504.
Cash flows from operations were a negative $408,270 for the three months
ended May 31, 1997, compared to negative $1,380,980 for the three months
ended May 31, 1996. This decrease was primarily due to a decrease in the net
loss of the Company due to factors previously discussed and an increase in
the Company's accounts payable and accrued expenses due to the Company's
limited cash resources.
Cash used in investing activities was approximately $279,232 for the
three months ended May 31, 1997, compared to approximately $195,535 for the
same period last year. This increase was due to an increase in development
expenses resulting from increased development activities on new products and
product upgrades.
Cash flows provided by financing activities were $709,906 for the three
months ended May 31, 1997, compared to $1,376,067 for the three months ended
May 31, 1996. This decrease was due primarily to less capital being raised
during this quarter compared to the same quarter last year and less debt
financing.
As a result of the aforementioned factors, cash and cash equivalents
increased by $22,404 for the three months ended May 31, 1997 versus a
decrease of approximately $56,705 for the same period last year.
4
<PAGE>
In April 1997, the Company entered into an Asset Sale Agreement with
Messrs. Gertner and Sharp, two of the Company's directors (the "Purchasers").
At the date of the agreement, the Purchasers owned approximately 31% of the
Company's outstanding Common Stock at that date. The Company sold to the
Purchasers, $3,750,000 of trade accounts receivable and forgave indebtedness
owed by the Purchasers to the Company in the amount of $72,000. The carrying
value of the receivables at April 1997, net of allowance, was
$1,931,500. Consideration received consisted of 3,900,000 shares of the
Company's Common Stock, with a market value of approximately $2,750,000, as
of the date of the transaction (for accounting purposes, the stock was valued
at approximately $2,003,500). The shares acquired represent approximately
23% of the Company's then issued and outstanding shares and are held as
treasury shares. Pursuant to the participation interest, Citadel will retain
a profits participation interest in the Assets in the event the Purchasers
collect in excess of $2,250,000 of the accounts receivable (after expenses of
collection), in which case the Purchasers shall pay to Citadel 50% of such
amounts collected in excess of $2,250,000. The transaction resulted in no
gain or loss to the Company.
In November 1996, the Company made a one-year, $625,000, 8% loan to GGS
Investment Company ("GGS"), a joint venture owned by Mr. Gertner, Chairman of
the Board of the Company, Mr. Sharp, former Chief Executive Officer of the
Company and Steven B. Solomon, former Chief Operating Officer of the Company,
who were also directors and owned an aggregate of approximately 6,800,000
shares of the Company's outstanding Common Stock, at that time. The purpose
of the joint venture was to invest in securities for short-term profits. The
loan agreement provided that interest would be waived for the first six
months in consideration of 100% of the net profits during that period being
paid to the Company. The loan was guaranteed by each of the officers, and
the guaranty was secured by a pledge of 754,000 shares of the Company's
Common Stock, valued at approximately $1,282,000 as of the date of the
transaction.
The joint venture was not profitable, and the loan was discharged in
April 1997 in the following manner: Mr. Solomon forgave $78,000 of accrued
compensation due him, Mr. Gertner assumed debt of approximately $275,000
(including accrued interest) due to a company controlled by him, Mr. Sharp
received a credit against the loan of $200,000 as consideration for agreeing
to terminate his noncancellable employment contract, and approximately
$72,000 was forgiven in connection with the Asset Sale Agreement discussed
above (reference is made to the Company's Annual Report on Form 10-KSB for
fiscal year ended February 28, 1997 for further discussion).
In March and April 1997, the Company conducted private placements of
convertible debt, which is convertible into common stock at an exercise price
equal to 75% of the average closing bid price for the five trading days prior
to the date of conversion. The Company raised net proceeds of approximately
$628,000 in these offerings which was used for working capital. In June
1997, the Company conducted a private placement of mandatory convertible debt
which is convertible into common stock at an exercise price equal to 75% of
the average bid price for the five trading days prior to the date of
conversion. The Company raised net proceeds of $1,000,000 in this offering
of which $500,000 was used to pay off convertible debt and $500,000 was used
for working capital.
As noted earlier, the Company has recently completed a plan of
reorganization which is expected to save the Company approximately $350,000
per month in operating expenses. In addition, the Company is working with
various vendors and lenders to restructure payables and debt that is
currently owed. However, even if the Company is successful with these
endeavors, the
5
<PAGE>
Company does not believe that the current funds available will be sufficient
to fund the Company's operations through the end of the year. As a result
the Company is seeking additional capital to fund its operations for the
remainder of the year, after which the Company believes its operations will
be self-sufficient. In October 1997, the Company received cash proceeds of
$750,000 and other valuable consideration from CORESTAFF in connection with
the sale of 2.5 million shares of the Company's common stock. While the
Company has been successful in the past in raising additional capital when
needed, there can be no assurance, however, that the Company will be successful
in raising capital in the future. The Company is continuing to look for
other sources of capital.
PART II. OTHER INFORMATION
Except as listed below, all information required by Part II is omitted
because the items are inapplicable or the answer is negative.
ITEM 1. LEGAL PROCEEDINGS
A former employee of the Company's predecessor filed a lawsuit against
the Company and one of its officers and directors alleging that the Company
and/or the individual owe the plaintiff additional stock options and seeking
damages in excess of $2,600,000. The Company and the individual believe such
claims are without merit and intends to vigorously defend against the claim
and is considering filing counterclaims. The Company has filed an answer in
the case, styled HEREDIA V. CITADEL, ET AL., in the 298th Court of Dallas
County, Texas.
One current and one former employee of the Company have filed a lawsuit
against the Company demanding payment of a promissory note issued in
connection with the acquisition of Kent-Marsh and ADI and seeking damages in
excess of $400,000. The Company believes it has defenses to payment under the
note. The Company is currently involved in negotiations with respect to the
settlement of the case. In the event the settlement negotiations are
unsuccessful, the Company intends to vigorously defend against the lawsuit.
The Company has filed an answer in the case, styled NESBITT & WESOLEK V.
CITADEL, in the 193rd District Court of Dallas County, Texas.
The Company is involved in an arbitration proceeding with Vestcom, a group
that claims it is entitled to compensation and a finder's fee for introducing
the Company to a third party. The Company believes it has defenses to such
arbitration claim. The Company intends to vigorously defend against the
claim.
At this time, the Company is unable to predict the ultimate outcome of these
suits, the costs associated with defending the claims and pursuing
counterclaims, and monetary compensation awarded, if any.
The Company is also involved in routine litigation from time to time. Such
litigation is not material to the Company's consolidated financial condition
or results of operations.
6
<PAGE>
ITEM 5. OTHER INFORMATION
In March 1996, in connection with the sale of its restaurants to Miami Subs
USA, Inc. ("Miami Subs"), the Company received 1,325,000 shares of Miami Subs
common stock and the assumption by Miami Subs of certain restaurant
indebtedness. The Company issued a nonrecourse, non-interest bearing,
promissory note to Miami Subs with a remaining principal amount of $1,250,000,
secured by a pledge of the aforementioned 1,325,000 shares of Miami Subs common
stock owned by the Company. As previously discussed, the Company determined
that it could not recover its investment in the Miami Subs stock and through a
charge to earnings of $1,000,000 wrote down the investment during the quarter
ended May 31, 1996, to its market value as of July 19, 1996. Subsequent to May
31, 1996, the Company through a charge to equity further wrote down the
investment in the Miami Subs stock to the carrying value of the debt. In June
1997, the Company tendered the stock to Miami Subs as payment in full of the
$1,250,000 debt owed by the Company to Miami Subs. In addition, to settle
certain disputes between the Company and Miami Subs, Miami Subs issued to the
Company 200,000 shares of Miami Subs common stock and agreed to assume
additional indebtedness related the Company's former restaurant operations. The
Company sold the shares for approximately $155,000 and used the proceeds for
working capital.
On September 22, 1997, the Company entered into a definitive agreement with
CORESTAFF, Inc. regarding the purchase of approximately 13% (2.5 million shares)
of the Company's outstanding common stock for $750,000 and other valuable
consideration, with warrants to purchase an additional 2 million shares (1
million at $4 and 1 million at $5). In addition, CORESTAFF's Software Services
Unit, Millennium, with a development staff of over 100, will supplement the
Company's research and development activities and each company will cross-sell
each others products and services with the Company being the exclusive
distributor of CORESTAFF's "First Step" software program, a peer-to-peer system
that enables users to easily access multiple systems requiring different user
codes. The transaction was closed on October 6, 1997.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
10.6 Agreement, dated April 11, 1997, among Citadel, George Sharp and Gil
Gertner. (incorporated by reference to Exhibit 99.1 of the Company's
Current Report on Form 8-K filed April 11, 1997)
10.7 Form of Offshore Securities Subscription Agreement, Convertible Notes,
Warrants and Registration Rights Agreement between Citadel Computer
Systems Incorporated and First Bermuda Securities Limited. (incorporated
by reference to Exhibits 99.1 through 99.4 of the Company's Current
Report on Form 8-K filed March 26, 1997)
10.8 Form of Offshore Securities Subscription Agreement, Convertible Notes,
Warrants and Registration Rights Agreement between Citadel Computer
Systems Incorporated and Willora Company Ltd. (incorporated by reference
to Exhibits 99.1 through 99.4 of the Company's Current Report on
Form 8-K filed April 28, 1997)
7
<PAGE>
10.9 Form of Offshore Securities Subscription Agreement, Convertible Notes,
Warrants and Registration Rights Agreement between Citadel Computer
Systems Incorporated and Silenus Ltd. (incorporated by reference to
Exhibits 99.1 through 99.4 of the Company's Current Report on Form 8-K
filed June 24, 1997)
10.10 Purchase Agreement between Citadel and CORESTAFF, Inc., dated
September 22, 1997 (incorporated by reference to Exhibit 10.10 of the
Company's Current Report on Form 10K for the year ended February 28,
1997).
(b) REPORTS ON FORM 8-K.
On March 26, 1997, the Company filed a Form 8-K with respect to an initial
closing on $1,000,000 of 5% redeemable convertible notes (which is part of a
private placement of up to $1,500,000 of 5% redeemable convertible notes) due
February 2000 (before fees and expenses). The notes were sold to certain
offshore accredited investors pursuant to Section 4(2) of the Securities Act of
1933, as amended, and Regulation S. The Company used the proceeds to retire
certain outstanding indebtedness and for working capital. The agreement
contains certain conversion restrictions as to the percentage of notes that may
be converted and when such conversions may be made. The principal amounts of
the notes may be converted, at the holders option, into common stock of the
Company at an exercise price between 80% and 75% of the average bid price for
the five trading days prior to the date of conversion, depending on the date of
conversion. No conversions are allowed prior to 41 days from the date of
closing. The Company had previously announced its intention to raise
approximately $3 million from a private placement during its fourth quarter. To
date, an aggregate of $1,000,000 of the notes, as disclosed above, were sold in
the placement. The Company determined to postpone the sale of the remaining
amounts, but may consider other financing alternatives in the future.
On April 11, 1997, the Company filed a Form 8-K with respect to an Asset
Sale Agreement with its Chairman and former President and Chief Executive
Officer ("purchasers") whereby the Company agreed to sell certain trade
receivables, amounting to approximately $3,735,000 (with a net carrying value
of approximately $1,865,000) in exchange for 3,900,000 shares of the
Company's common stock (approximate market value as of the date of the
transaction $2,769,000). In addition, the agreement called for certain
indebtedness of the parties to be forgiven and certain indebtedness of the
Company to be assumed by the purchasers. The agreement also provides that
the Company will receive 50% of the proceeds collected on the receivables
sold in excess of $2,250,000 and the employment contract of the Company's
former President be terminated immediately. The transaction resulted in no
gain or loss to the Company during the quarter. On April 11, 1997, the Board
of Directors of the Company authorized the redemption of all or a portion of
its Convertible Redeemable Debentures due 2000 and Series B Convertible
Preferred Stock upon notice of conversion. The Board has initially
authorized up to $1.5 million for redemption, in amounts, and at times
depending on market conditions.
On April 28, 1997, the Company filed a Form 8-K with respect to the
completion of a private placement of $500,000 of 8% Convertible Redeemable
Debentures as of April 11, 1997, due April
8
<PAGE>
11, 2000. The notes were sold to certain offshore accredited investors
pursuant to Section 4(2) of the Securities Act of 1933, as amended, and
Regulation S. The Company used the proceeds to retire certain outstanding
indebtedness and for working capital. The agreement contains certain
redemption provisions which allow the Company to redeem all or a portion of
the notes at a certain premium, depending on the date of redemption. The
principal amounts of the notes may be converted, after 45 days and at the
holders option, into common stock of the Company at an exercise price of 75%
of the average bid price for the five trading days prior to the date of
conversion.
On June 24, 1997, the Company filed a Form 8-K with respect to the
completion of a private placement of $1,125,000 of 8% redeemable convertible
notes due June 9, 2000 (before fees and expenses). The notes were sold to
certain offshore accredited investors pursuant to Section 4(2) of the Securities
Act of 1933, as amended, and Regulation S. The Company used the proceeds to
retire certain convertible notes and for working capital. The agreement
contains certain redemption provisions which allow the Company to redeem all or
a portion of the notes at a certain premium, depending on the date of
redemption. The principal amounts of the notes may be converted, after 45 days
and at the holders option, into common stock of the Company at an exercise
price of 75% of the average bid price for the five trading days prior to the
date of conversion.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
CITADEL COMPUTER SYSTEMS INCORPORATED
(REGISTRANT)
<TABLE>
<S> <C>
Date: October 17, 1997 By: /s/ Steven B. Solomon
----------------------------------------------------------
Steven B. Solomon, President and Chief Executive Officer
(Duly Authorized Signatory and Principal Executive Officer)
By: /s/ Richard L. Travis, Jr.
----------------------------------------------------------
Richard L. Travis, Jr., Chief Operating and Financial Officer
(Duly Authorized Signatory and Principal Financial Officer)
</TABLE>
9
<PAGE>
PART I. FINANCIAL INFORMATION -- ITEM 1. FINANCIAL STATEMENTS
CITADEL COMPUTER SYSTEMS INCORPORATED
10
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
CONSOLIDATED BALANCE SHEETS
May 31, February 28,
ASSETS 1997 1997
------------------------
CURRENT ASSETS
Cash $ 37,504 $ 15,100
Accounts receivable, less allowance for returns and
doubtful accounts of $522,274 and $625,000 764,839 727,422
Notes receivable from related parties 337,968 870,000
Marketable securities available for sale 1,250,000 1,250,000
Other 139,048 57,106
------------------------
Total current assets 2,529,359 2,919,628
ACCOUNTS RECEIVABLE - NONCURRENT, less
allowance for returns and doubtful accounts
of $1,875,000 - 1,875,000
PROPERTY AND EQUIPMENT, NET 489,073 696,459
PURCHASED SOFTWARE, NET OF ACCUMULATED
AMORTIZATION OF $1,049,662 AND $854,000 4,200,738 4,396,398
CAPITALIZED SOFTWARE DEVELOPMENT COSTS,
NET OF ACCUMULATED AMORTIZATION OF $44,125 AND $19,000 694,174 573,388
OTHER ASSETS 265,252 263,220
------------------------
$8,178,596 $10,724,093
------------------------
------------------------
The accompanying notes are an integral part of these statements.
11
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
CONSOLIDATED BALANCE SHEETS - CONTINUED
May 31, February 28,
LIABILITIES AND STOCKHOLDERS' EQUITY 1997 1997
--------------------------
CURRENT LIABILITIES
Cash overdraft $ - $ 167,256
Current maturities of long-term debt 786,750 804,141
Notes payable 2,194,847 2,456,087
Accounts payable and accrued expenses 2,589,140 2,253,481
--------------------------
Total current liabilities 5,570,737 5,680,965
LONG-TERM LIABILITIES
Debt, less current maturities 1,585,861 1,770,905
--------------------------
Total liabilities 7,156,598 7,451,870
COMMITMENTS AND CONTINGENCIES - -
STOCKHOLDERS' EQUITY
Common stock, $.01 par value per share; authorized,
30,000,000 shares; issued, 18,492,700 shares
at 5/31/97 and 16,501,980 shares at 2/28/97 184,927 165,020
Preferred stock, $.01 par value per share;
authorized, 1,000,000 shares; issued and
outstanding, 545 shares of Series B convertible
(liquidation value of $545,000) - 5
Equity notes 850,000 300,000
Additional paid-in capital 13,444,151 13,370,627
Accumulated deficit (10,718,186) (9,854,067)
Unrealized loss on securities available for sale (355,772) (355,772)
Treasury stock, at cost (4,164,613 shares at
5/31/97 and 264,613 shares at 2/28/97) (2,386,121) (353,590)
--------------------------
Total stockholders' equity 1,021,998 3,272,223
--------------------------
$ 8,178,596 $10,724,093
--------------------------
--------------------------
The accompanying notes are an integral part of these statements.
12
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS
For the three months ended May 31,
1997 1996
---------------------------
REVENUES
Sales $ 498,069 $ 1,183,116
Less returns for allowances 5,795 58,705
---------------------------
Net sales 492,274 1,124,411
COST OF SALES 9,411 46,872
---------------------------
Gross profit 482,863 1,077,539
OPERATING EXPENSES
Selling, general and administrative expenses 1,003,695 1,441,073
Depreciation and amortization 274,172 164,648
Research and development expense 38,296 48,723
---------------------------
1,316,163 1,654,444
---------------------------
Operating loss (833,300) (576,905)
OTHER INCOME (EXPENSE)
Interest expense (21,226) (34,652)
Write-down of marketable securities - (1,000,000)
Other (6,593) -
---------------------------
(27,819) 1,034,652
---------------------------
NET LOSS $ (861,119) $(1,611,557)
---------------------------
---------------------------
Loss per share $ (.06) $ (.14)
---------------------------
---------------------------
Weighted average shares outstanding 15,420,384 11,746,709
---------------------------
---------------------------
The accompanying notes are an integral part of these statements.
13
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the three months ended May 31,
1997 1996
--------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $ (861,119) $(1,611,557)
Adjustments to reconcile net loss to net cash
used by operating activities
Write-down of available for sale securities - 1,000,000
Depreciation and amortization 274,172 164,648
Changes in operating assets and liabilities
Accounts receivable (93,917) (479,489)
Other receivables (92,968) -
Other current assets (81,942) (73,208)
Bank overdraft (167,256) -
Accounts payable and accrued expenses 616,792 (506,408)
Other assets (2,032) 125,034
--------------------------
NET CASH USED BY OPERATING ACTIVITIES (408,270) (1,380,980)
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures (133,321) (125,270)
Development of software (145,911) (70,265)
--------------------------
NET CASH USED BY INVESTING ACTIVITIES (279,232) (195,535)
CASH FLOWS FROM FINANCING ACTIVITIES
Payments on notes payable (11,240) (37,822)
Proceeds from notes payable - 415,000
Repayments on long-term debt (67,280) -
Proceeds from sale of equity & convertible notes 695,000 -
Proceeds from sale of common stock 93,426 1,104,046
Decrease in assets under contract for sale - net - 38,586
--------------------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 709,906 1,376,067
--------------------------
14
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
For the three months ended May 31,
1997 1996
--------------------------
Net increase (decrease) in cash 22,404 (56,705)
Cash at beginning of the period 15,100 125,565
--------------------------
Cash at end of the period $ 37,504 $ 68,860
--------------------------
--------------------------
Supplemental disclosure of cash flow information:
Non Cash investing and financing transactions:
Sale of receivables - net $ 1,931,500
Sale of furniture and fixtures - net 287,322
Notes receivable from related parties 625,000
Long term debt assumed by purchasers (250,000)
Notes payable assumed by purchasers (280,155)
Accounts payable and accrued liabilities assumed (281,136)
Purchase of treasury stock (2,032,531)
15
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A - BASIS OF PRESENTATION
The financial information presented herein should be read in conjunction with
the financial statements and footnotes included in the Company's Annual
Report on Form 10-KSB for the period ended February 28, 1997. The balance
sheet as of February 28, 1997 has been derived from the audited financial
statement at that date.
The accompanying unaudited financial statements have been prepared in
accordance with generally accepted accounting principles for interim
financial information and have been presented on the basis that the Company
is a going concern, which contemplates the realization of assets and
satisfaction of liabilities in the normal course of business. See Note C to
the Notes to Financial Statements contained in the Company's Form 10-KSB for
the year ended February 28, 1997. Accordingly, they do not include all of
the information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of management,
all adjustments considered necessary for a fair presentation, consisting of
those of a normal recurring nature, are reflected in the accompanying
financial statements.
NOTE B - STOCKHOLDERS' EQUITY
Balance at February 28, 1997 $3,272,223
Issuance of equity notes - net 700,000
Purchase of treasury stock (2,032,531)
Conversion of debt to equity 85,000
Expenses of offerings (141,575)
Net loss (861,119)
----------
Balance at May 31, 1997 $1,021,998
----------
----------
16
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOTE C - RELATED-PARTY TRANSACTIONS
JOINT VENTURE
In November 1996, the Company made a one-year, $625,000, 8% loan to GGS
Investment Company (GGS), a joint venture owned by Gilbert Gertner,
Chairman of the Board of the Company, George Sharp, Chief Executive
Officer of the Company and Steven B. Solomon, Chief Operation Officer of
the Company, who were also directors and owned approximately 46% of the
Company's outstanding common stock at that time. The purpose of the
joint venture was to invest in securities for short-term profits. The
loan agreement provided that interest would be waived for the first
six months in consideration of 100% of the net profits, during that
period, being paid to the Company.
The loan was guaranteed by each of the officers, and the guaranty was
secured by the pledge of a total of 754,000 shares of the Company's
common stock, valued at approximately $1,282,000 as of the date of the
transaction.
The joint venture was not profitable, and the loan was discharged by GGS
in April 1997 in the following manner: Mr. Solomon forgave $78,000 due
from the Company to him, Mr. Gertner assumed debt of the Company to a
corporation controlled by him in the principal amount of $250,000 plus
accrued interest of approximately $25,000, and Mr. Sharp received a
credit against the loan of $200,000 as consideration for agreeing to
terminate his non-cancelable employee contract aggregating approximately
$700,000 through November 2000 and $72,000 was forgiven in connection
with the asset sale agreement discussed below.
ASSET SALE AGREEMENT
In April 1997, the Company entered into an asset sale agreement with its
former Chief Executive Officer and its Chairman of the Board (the
Purchasers) jointly. At the date of the agreement, the Purchasers owned
approximately 31% of the Company's outstanding common stock at that date.
The Company sold to the Purchasers, $3,750,000 of trade accounts
receivable and forgave indebtedness owed by the Purchasers to the Company
in the amount of $72,000. The carrying value of the receivables at
February 28, 1997, net of allowance, was $1,931,500. Consideration
received consisted of 3,900,000 shares of the Company's common stock with
a market value of approximately $2,750,000 as of the date of the
transaction. For accounting purposes, the Company has valued the shares
at approximately $2,003,500. The agreement provides that the Company
will also receive 50% of the proceeds in excess of $2,250,000 from
collection of the receivables. The transaction resulted in no gain or
loss to the Company in the quarter.
17
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOTE D - COMMITMENTS AND CONTINGENCIES
A former employee of Old LoneStar filed a lawsuit against the Company and
one of its officers and directors alleging that the Company and/or the
individual owe the plaintiff additional stock options and seeking damages
of $2,600,000. The Company believes such claims are without merit and
intends to vigorously defend against the claim.
One current and one former employee of the Company have filed a lawsuit
against the Company demanding payment of a promissory note issued in
connection with the acquisition of Kent-Marsh and ADI and seeking damages
in excess of $400,000. The Company believes it has defenses to payment
under the note. The Company is currently involved in negotiations with
respect to the settlement of the case. In the event the settlement
negotiations are unsuccessful, the Company intends to vigorously defend
against the lawsuit. The Company has filed an answer in the case, styled
NESBITT & WESOLEK V. CITADEL, in the 193rd District Court of Dallas
County, Texas.
An unrelated company has filed a lawsuit against the Company and one of
its officers and directors alleging that the Company and/or the officer
owe the plaintiff a finder's fee and is seeking $100,000 of the Company's
common stock. The Company believes such claims are without merit and
intends to vigorously defend against the claim.
The Company is also involved in various legal actions arising in the
normal course of business. Management is of the opinion that their
outcome will not have a material adverse effect on the Company's
financial position or results of operations.
NOTE E - SUBSEQUENT EVENTS
In June 1997, the Company sold $1,125,000 of 8% redeemable convertible
notes due June 9, 2000 (before fees and expenses). The notes were sold
to offshore accredited investors pursuant to Section 4(2) of the Securities
Act of 1933, as amended, and Regulation S. The Company used the proceeds to
retire certain convertible notes and for working capital.
On September 1997, the Company signed a definite letter of intent with
CORESTAFF, Inc. ("CORESTAFF") whereby CORESTAFF agreed to purchase 2.5
million shares of the Company's common stock for $750,000 and other
valuable consideration, with warrants to purchase an additional 2 million
shares (1 million at $4 and 1 million at $5). CORESTAFF is one of the
largest providers of information technology and staffing services in the U.S.
As part of the agreement, CORESTAFF's Software Services Unit, Millenium
Computer Corporation, with a development staff in excess of 100, will
provide development support for the Company. In addition, each company
will cross-sell each others products, with Citadel being the exclusive
distributor of CORESTAFF's "First Step" software program, a peer-to-peer
system that enables users to easily access multiple systems requiring
different user codes. The transaction closed on October 6, 1997.
18
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS OF CITADEL COMPUTER SYSTEMS INCORPORATED FOR THE
QUARTER ENDED MAY 31, 1997 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> FEB-28-1998
<PERIOD-START> MAR-01-1997
<PERIOD-END> MAY-31-1997
<CASH> 37,504
<SECURITIES> 1,250,000
<RECEIVABLES> 764,839
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 2,159,359
<PP&E> 489,073
<DEPRECIATION> 0
<TOTAL-ASSETS> 8,178,596
<CURRENT-LIABILITIES> 5,570,737
<BONDS> 1,585,861
0
0
<COMMON> 184,927
<OTHER-SE> 837,071
<TOTAL-LIABILITY-AND-EQUITY> 8,178,596
<SALES> 492,274
<TOTAL-REVENUES> 492,274
<CGS> 9,411
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 21,226
<INCOME-PRETAX> (861,119)
<INCOME-TAX> 0
<INCOME-CONTINUING> (861,119)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (861,119)
<EPS-PRIMARY> (.06)
<EPS-DILUTED> 0
</TABLE>
