<PAGE>
UNITED STATES 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, 1998
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
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COMMISSION FILE NUMBER: 0-08718
CITADEL TECHNOLOGY, INC.
(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)
Indicate by check mark 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
--- ---
Indicate the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date.
Class Outstanding at July 15, 1998
- -------------------------------------- ----------------------------
Common Stock, Par value $.01 per share 26,318,884
Transitional Small Business Disclosure Format Yes [ ] No [X]
<PAGE>
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, 1998, the Company had net sales of
$1,034,195, an increase of $541,921, or 110.1% over net sales of $492,274
during the three months ended May 31, 1997. The Company attributes the sales
increase to increased industry recognition of its products and the recent
partnering relationships with System Plan, in Japan and Guildsoft, Ltd., in
England and its bundling arrangements with Microsoft and Compaq.
During the quarter, as mentioned previously, the Company entered into
partnering relationships related to the distribution of the Company's
products overseas with Guildsoft Ltd., in England, and System Plan, in Japan.
In addition, during the quarter the Company entered into additional bundling
arrangements with Microsoft and Compaq related to its Winshield and
Folderbolt products.
The Company launched its WinShield NT and Network products during the quarter
and is in beta testing on its CPR and FolderBolt 95 and NT products. The
Company expects to launch these products during the second and third quarters
of fiscal 1999. The Company also expects to launch its Citadel Secure
Desktop product and other new products and upgrades that will provide
ease-of-use security solutions for Internet and intranet applications on
Microsoft and Novell platforms in the future quarters of fiscal 1999.
The costs and expenses incurred in connection with producing the Company's
products were $70,331 during the quarter, an increase of $60,900 or 547.1%
over cost of sales of $9,411 for the same period last year. As a percentage
of sales, the Company's cost of sales for the quarter increased from 1.9% for
the three months ended May 31, 1997 to 6.8% for the three months ended May
31, 1998. The increase in cost of sales for the current quarter over the same
quarter last year can be attributed to a change in the product sales mix,
during the quarter, to lower priced products sold on an individual unit basis
and the establishment of a reserve for potential product returns. Both
factors can be attributed to the Company's recent entry into the retail sales
channel, which the Company was not engaged in during the same period last
year. In addition, and partly due to its entry into the retail channel, the
Company completely updated its packaging and collateral pieces to give all
its products a common look. This also tended to increase the Company's cost
of sales on a per unit basis. The impact of the aforementioned was offset,
to some degree, by the increase in the Company's bundling revenues over the
same quarter last year, which tends to reduce the cost of sales on a
percentage basis.
Research and development costs charged to expense for the quarter were
approximately $104,724 versus $150,524 for the same period last year, or a
decrease of $45,800 or 30.4%. Development costs of $498,503 and $145,911
for the quarters ended May 31, 1998 and 1997, respectively, were capitalized.
The increase in capitalized costs relates to the increased level of
development activity during the quarter. The Company, through its
association with Metamor Worldwide Inc., was able to devote substantially
more resources this quarter to development activities than
2
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was possible in previous quarters. The Company, as it continues to upgrade
and expand its product offerings, expects that its level of development
activity in future quarters will continue to exceed its levels of comparable
past quarters. The Company expects to launch additional new products and
upgrades in the future quarters of fiscal 1999 that will provide for ease of
security solutions for Internet and intranet applications on Microsoft and
Novell platforms.
Selling and marketing expenses increased from $307,629 for the quarter ended
May 31, 1997 to $471,394 for the quarter ended May 31, 1998, or 53.2%.
However, as a percentage of sales, selling and marketing expenses for the
quarter decreased from 62.5% to 45.6%. The Company expects that it will
continue to allocate additional resources to selling and marketing expenses
in the future. Therefore, the Company would expect that in the future, these
expenses will continue to increase on a dollar basis, but as sales increase
these expenses should continue to decrease as a percentage of sales.
General and administrative expenses decreased $228,499, or 39.1% from
$583,838 for the quarter ended May 31, 1997 to $355,339 for the quarter ended
May 31, 1998. This resulted primarily from the Company's restructuring and
cost control programs implemented during the second quarter of last year. As
a percentage of sales, these expenses decreased from 118.6% in 1997 to 34.3%
in 1998. The Company would expect that as revenues increase these expenses
would continue to decrease as a percentage of sales.
Depreciation and amortization expense increased $78,254 or 28.5%, to
$352,426 from $274,172 for the three months ended May 31, 1998 and 1997,
respectively. This increase resulted from the commencement of amortization on
certain capitalized research and development costs relating to products that
became available for sale during the quarter. The Company would expect these
expenses to continue to increase in the future as additional products become
available for sale.
Interest expense for the three months ended May 31, 1998 increased to
$51,204, an increase of $29,978 or 141.2% over interest expense of $21,226
during the same period last year. This resulted primarily from the Company
having more interest bearing debt in place during this quarter than during
the quarter ended May 31, 1997.
As a result of the foregoing, the Company, for the three months ended May 31,
1998, reported a net loss before extraordinary items of $371,223, compared to
a net loss of $861,119 for the same period last year.
During the quarter, the Company recognized a gain on the settlement of debts
of $527,221 relating primarily to the restructuring of a certain note payable
to Inxight, a division of Xerox. In connection with the restructuring,
Inxight agreed to reduce a certain note and accrued interest due from the
Company by $520,816. In exchange, the Company agreed to a shorter maturity
on the note and the issuance of 250,000 shares of the Company's Common Stock
to Inxight (valued at $92,500 as of the date of the transaction). The value
of the stock has been treated as a reduction in the gain associated with the
transaction. The remaining balance relates to miscellaneous gains
recognized by the Company associated with the settlement of balances due
various vendors during the quarter.
As a result of the aforementioned, the Company, for the three months ended
May 31, 1998, reported a net profit of $155,998, compared to a net loss of
approximately $861,119 for the same period last year.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash and cash equivalents at May 31, 1998 were $1,247,569.
Cash flow from operations was a negative $3,272,821 for the three months
ended May 31, 1998, compared to negative $408,270 for the three months ended
May 31, 1997. This increase was primarily due to an increase in the
Company's trade receivables, which increased due to the increase in the
Company's revenues during the quarter; this was offset by a decrease in the
net loss of the Company due to factors previously discussed. In addition to
the aforementioned, the Company's operational cash flow was impacted by a
receivable the Company recorded of $2,500,000, which related to a certain
Common Stock sale transaction at the end of the Company's quarter. The
Company, subsequent to the end of the quarter, received the funds.
Cash used in investing activities was approximately $507,872 for the three
months ended May 31, 1998, compared to approximately $279,232 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.
3
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Cash provided by financing activities was $5,019,707 for the three months
ended May 31, 1998, compared to $709,906 for the three months ended May 31,
1997. This increase was due primarily to more capital being raised during
this quarter compared to the same quarter last year.
As a result of the aforementioned factors, cash and cash equivalents
increased by $1,239,014 for the three months ended May 31, 1998 versus an
increase of approximately $22,404 for the same period last year.
On April 13, 1998, the Company received a loan in the amount of $250,000 from
an individual. The loan bears interest at 10% per annum and is payable in
full on or before July 13, 1998. On May 26, 1998, the individual exercised
his option and converted this debt into shares of the Company's Series D
Convertible Redeemable Preferred Stock. See Part II, Item 2 - "Recent Sales
Of Unregistered Securities During The Quarter."
On April 30, 1998, the Company and Precision Capital Investors Limited
Partnership I ("Precision") entered into a Securities Purchase Agreement (the
"Purchase Agreement") pursuant to which Precision purchased shares of 6%
Series E Convertible Redeemable Preferred Stock for $500,000. See Part II,
Item 2 -"Recent Sales Of Unregistered Securities During the Quarter." The
Company, on June 30, 1998, exercised its option and redeemed in full this
issuance.
On May 15, 1998, the Company and Metamor Worldwide, Inc. (formerly CORESTAFF,
Inc.) ("Metamor") entered into a Stock Purchase Agreement (the "Stock
Purchase Agreement") pursuant to which Metamor purchased 2,000 shares of
Citadel's 11% Series D Convertible Redeemable Preferred Stock for proceeds of
$2,000,000. See Part II, Item 2 - "Recent Sales Of Unregistered Securities
During The Quarter."
On May 26, 1998, the Company and Icarus Investments I, Ltd. ("Icarus")
entered into a Stock Purchase Agreement pursuant to which Icarus purchased
2,000,000 shares of Citadel's Common Stock for proceeds of $2,500,000. See
part II, Item 2 - "Recent Sales Of Unregistered Securities During The
Quarter." On June 30, 1998, Icarus purchased an additional 1,000,000 shares
of Citadel's Common Stock for proceeds of $1,500,000." See Part II, Item 5 -
"Other Information."
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 LoneStar (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,
were obligated to pay the exercise price for certain stock options, and
breached a purported agreement to register certain stock held by the
plaintiff. The plaintiff is seeking damages of approximately $2,300,000, plus
attorneys' fees, pre- and post-judgement interest and costs of the lawsuit.
The Company and the individual believe such claims are without merit and
intend to vigorously defend against the claims and are considering filing
counter-claims. The Company has filed an answer in the case, styled HEREDIA
V. CITADEL, ET. AL., in the 298th Court of Dallas County, Texas.
Two former employees of the Company have lawsuits pending against the Company
demanding payment of a promissory note issued in connection with the
acquisition of Kent-Marsh and Astonishing Developments, Inc. and are seeking
damages in excess of $400,000. The Company recently reached a settlement
with one of the employees under the terms of a promissory note and agreed
judgement. The court severed the claims of the remaining party, who amended
his claims to include amounts allegedly owing under an employment agreement
(in the amount of approximately $168,000). The Company believes it has
defenses to payment under the note and employment agreement and intends to
vigorously defend against the lawsuit and pursue counterclaims. The Company
has filed an answer in the case, styled NESBITT & WESOLEK V. CITADEL, in the
193rd District Court of Dallas County, Texas.
On January 7, 1998, the Company's former Houston landlord filed a lawsuit
against the Company, styled LENHNDORFF FOUR OAKS PLACE JOINT VENTURE V.
CITADEL, in the 11th Judicial District Court of Harris County, Texas,
alleging that the Company breached a certain lease covering the Company's
former Houston office space. The suit seeks damages to date of approximately
$180,000, plus attorney's fees, pre- and post-judgment interest and court
costs. The Company believes that it has viable defenses against such a claim
and is in the process of filing a counter-suit against the plaintiff.
4
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The Company and its president are involved in an arbitration proceeding,
styled VESTCOM LTD. V. CITADEL COMPUTER SYSTEMS, INCORPORATED before the
American Arbitration Association in Los Angeles, California. Vestcom claims
it is entitled to compensation and a finder's fee for introducing the Company
to a third party and is seeking damages of $100,000 in shares of the
Company's Common Stock plus 50% of additional consideration paid by the
Company to such a third party. The Company and its president believe they
have defenses to such claim. Vestcom agreed to stay the arbitration
proceeding pending a decision on one of the Company's defenses in Texas state
court. The case is styled CITADEL COMPUTER SYSTEMS, INC. AND STEVEN B.
SOLOMON V. VESTCOM, LTD., in the 193rd Judicial District Court in Dallas
County, Texas. In June 1998, the Texas state court made an oral ruling in
favor of the Company and its president that the purported agreement was a
forgery. In the event the court issues a written opinion in accordance with
its oral ruling, the arbitration proceedings should be permanently enjoined.
The Company intends to vigorously defend against the claim.
On October 12, 1998, five former employees of the Company filed a lawsuit
against the Company and one current and one former officer and director. The
suit alleges that the Company and/or the individuals owe the plaintiffs free
trading stock options in lieu of certain amounts claimed to be due to them
for salary, bonus or override compensation, and seeks damages, attorney's
fees, pre-and post-judgment interest and costs allegedly in excess of
$4,000,000. The Company and the individuals believe such claims are without
merit and intend to vigorously defend against the claims. The lawsuit is
styled MARKS, MARKS, RANSHAW, COLQUITT & LAURATIS V. CITADEL COMPUTER
SYSTEMS, INC., et al., in the 189th Judicial District Court of Harris County,
Texas.
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.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
RECENT SALES OF UNREGISTERED SECURITIES DURING THE QUARTER
In January 1998, the Company received a loan in the amount of $400,000 from
Thomas E. Oxley. In connection with the loan, Mr. Oxley received warrants to
purchase 200,000 shares of common stock at $.32 per share (the then fair
market value of the Company's common stock at the date of the transaction).
The warrants vested immediately and expire on January 5,1999. In May 1998,
Mr. Oxley converted this debt into shares of the Company's Common Stock. Such
securities were not registered under the Securities Act of 1933, as amended
(the "Securities Act"), in reliance upon Section 4(2) of the Securities Act
and Rule 506 of Regulation D thereunder. No underwriters were involved in
connection with the sale of the securities.
In April 1998, the Company received a loan in the amount of $250,000 from
Edward Coppola. The loan bore interest at 10% per annum and is payable in
full on or before July 13, 1998. In connection with the loan, the Company
issued warrants to purchase 100,000 shares of the Company's Common Stock at
$.50 per share (the fair market value of the Company's Common Stock at the
date of the transaction). The warrants vest immediately and expire on April
1, 2001. Mr. Coppola has the right to convert this debt into shares of the
Company's Series D Convertible Redeemable Preferred Stock (the terms of which
are described below). Such securities were not registered under the
Securities Act, in reliance upon Section 4(2) of the Securities Act and Rule
506 of Regulation D thereunder. No underwriters were involved in connection
with the sale of the securities. On May 26, 1998, Mr. Coppola converted this
debt into shares of the Company's Series D Convertible Redeemable Preferred
Stock.
On April 30, 1998, the Company and Precision Capital Investors Limited
Partnership I ("Precision") entered into a Securities Purchase Agreement (the
"Purchase Agreement") pursuant to which Precision purchased shares of 6%
Series E Convertible Redeemable Preferred Stock for $500,000. The Series E
Preferred Stock was redeemed by the Company at a redemption price in cash
equal to 112.5% of the original issue price, plus accrued and unpaid
dividends to the redemption date. In connection with the transaction, the
Company also issued warrants to purchase up to 100,000 shares of the
Company's common stock at $0.75 per share (above the fair market value of the
Company's common stock at the date of the transaction), which expire on April
30, 2001. Such securities were not registered under the Securities Act, in
reliance upon
5
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On May 15, 1998, the Company and Metamor Worldwide, Inc. (formerly Corestaff,
Inc.) ("Metamor") entered into a Stock Purchase Agreement (the "Stock
Purchase Agreement") pursuant to which Metamor purchased 2,000 shares of
Citadel's 11% Series D Convertible Redeemable Preferred Stock for proceeds of
$2,000,000. The preferred shares are convertible into Common Stock of the
Company at the election of the holder at a conversion price equal to 150% of
the twenty day average of the closing bid price of the Company's Common Stock
prior to the closing of the purchase ($1.07 per share). The preferred shares
will automatically convert into shares of Common Stock upon (i) the closing
of an underwritten public offering that values the Company at a minimum
equity value of $20,000,000 with proceeds to the Company of a minimum of
$10,000,000 before expenses, or (ii) the date at which the Company's Common
Stock maintains a closing bid price that is 100% greater than the conversion
price for at least 20 consecutive days. Such shares were not registered
under the Securities Act, in reliance upon Section 4(2) of the Securities Act
and Rule 506 of Regulation D thereunder. No underwriters were involved in
connection with the sale of the shares under the Stock Purchase Agreement.
Beginning one year from the date of closing, the Company may redeem all or
part of the unconverted preferred shares based on a redemption price equal to
120% of the issuance price if redeemed prior to two years after the closing,
115% of the issuance price if redeemed prior to three years after the
closing, or 100% of the issuance price if redeemed prior to four years after
the closing.
On May 26, 1998, the Company and Icarus Investments I, Ltd. ("Icarus")
entered into a Stock Purchase Agreement pursuant to which Icarus purchased
2,000,000 shares of Citadel's Common Stock for proceeds of $2,500,000. Such
shares were not registered under the Securities Act, in reliance upon Section
4(2) of the Securities Act and Rule 506 of Regulation D thereunder. In
connection with the transaction, the Company issued warrants to purchase
500,000 shares of the Company's Common Stock at $4.00 per share and 500,000
at $5.00. No underwriters were involved in connection with the sale of the
shares under the Stock Purchase Agreement.
ITEM 5. OTHER INFORMATION
On June 30, 1998, the Company and Icaurs Investments I, Ltd. ("Icarus")
entered into a Stock Purchase Agreement pursuant to which Icarus purchased
1,000,000 shares of Citadel's Common Stock for proceeds of $1,500,000. Such
shares were not registered under the Securities Act, in reliance upon Section
4(2) of the Securities Act and Rule 506 of Regulation D thereunder. No
underwriters were involved in connection with the sale of the shares under
the Stock Purchase Agreement.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
3.10 Certificate of Amendment to Certificate of Incorporation filed with the
Delaware Secretary of State on February 27, 1998 (incorporated by reference
to Exhibit 4.2 of the Company's Registration Statement on Form S-8 filed May
20, 1998, File No. 333-53131).
3.11 Certificate of Designations of Series C Preferred Stock (incorporated
by reference to Exhibit 4.6 of the Company's Registration Statement on Form
S-8 filed May 20, 1998, File No. 333-53131).
3.12 Certificate of Designations of Series D Preferred Stock (incorporated
by reference to Exhibit 4.8 of the Company's Registration Statement on Form
S-8 filed May 20, 1998, File No. 333-53131).
3.11 Certificate of Designations of Series E Preferred Stock (incorporated
by reference to Exhibit 4.7 of the Company's Registration Statement on Form
S-8 filed May 20, 1998, File No. 333-53131).
10.12 Series D Preferred Stock Purchase Agreement between Citadel and Metamor
Worldwide, Inc., dated May 15, 1998 (incorporated by reference to Exhibit
10.12 of the Company's Annual Report on Form 10-KSB for the year ended
February 28, 1998).
10.13 Stock Purchase Agreement between Citadel and Precision Capital Limited
Partnership I, dated April 30, 1998 (incorporated by reference to Exhibit
10.13 of the Company's Annual Report on Form 10-KSB for the year ended
February 28, 1998).
10.14 Stock Purchase Agreement between Citadel and Icarus Investments I,
Ltd., dated May 27, 1998 (incorporated by reference to Exhibit 10.14 of the
Company's Annual Report on Form 10-KSB for the year ended February 28, 1998).
6
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REPORTS ON FORM 8-K.
The Company filed no Current Reports on Form 8-K during the quarter ended May
31, 1998.
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 TECHNOLOGY, INC.
(REGISTRANT)
<TABLE>
<S> <C>
Date: July 15, 1998 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>
7
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CITADEL TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
MAY 31, FEBRUARY 28,
ASSETS 1998 1998
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<S> <C> <C>
CURRENT ASSETS
Cash $ 1,247,569 $ 8,555
Accounts receivable, less allowance for returns and
doubtful accounts of $629,000 and $681,000 1,140,375 435,615
Notes receivable from related parties 378,100 376,487
Subscription receivable 2,500,000 -
Inventories 113,308 57,512
Other 337,426 71,981
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Total current assets 5,716,778 950,150
PROPERTY AND EQUIPMENT, NET 350,737 387,923
PURCHASED SOFTWARE, net of accumulated
amortization of $2,020,000 and $1,788,000 3,229,902 3,462,879
CAPITALIZED SOFTWARE DEVELOPMENT COSTS,
net of accumulated amortization of $223,000 and $150,000 1,437,041 1,011,432
OTHER ASSETS 183,387 350,650
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$ 10,917,845 $ 6,163,034
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</TABLE>
The accompanying notes are an integral part of these statements.
8
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CITADEL TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS - CONTINUED
<TABLE>
MAY 31, FEBRUARY 28,
LIABILITIES AND STOCKHOLDERS' EQUITY 1998 1998
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<S> <C> <C>
CURRENT LIABILITIES
Cash overdraft $ - $ 10,249
Current maturities of long-term debt 1,177,781 1,270,565
Notes payable 416,093 842,174
Accounts payable and accrued expenses 2,266,914 2,274,141
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Total current liabilities 3,860,788 4,397,129
LONG-TERM LIABILITIES
Debt, less current liabilities 74,910 478,044
------------ ------------
Total liabilities 3,935,698 4,875,173
COMMITMENTS AND CONTINGENCIES - -
STOCKHOLDERS' EQUITY
Common stock, $.01 par value per share; authorized
60,000,000 shares; issued, 29,180,800 shares
at 5/31/98 and 25,881,328 shares at 2/28/98 291,808 258,813
Preferred stock, $.01 par value per share;
authorized 1,000,000 shares; issued and outstanding
Series B convertible, 50 shares (liquidation value $50,000) 1 1
Series C convertible, 4,250 shares at 5/31/98 and 5,000 shares 43 50
at 2/28/98 (liquidation value $425,000 and $500,000)
Series D convertible, 2,253 shares (liquidation value $2,253,000) 23 -
Series E convertible, 5,000 shares (liquidation value $500,000) 50 -
Equity Notes 944,000 944,000
Additional paid-in capital 21,663,669 16,158,442
Accumulated deficit (13,417,208) (13,573,206)
Unrealized loss on securities available for sale - -
Treasury stock, at cost (4,164,613 shares) (2,500,239) (2,500,239)
------------ ------------
Total stockholders' equity 6,982,147 1,287,861
------------ ------------
$ 10,917,845 $6,163,034
------------ ------------
------------ ------------
</TABLE>
The accompanying notes are an integral part of these statements.
9
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CITADEL TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
THREE MONTHS ENDED
MAY 31,
1998 1997
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<S> <C> <C>
Gross sales $ 1,076,426 $ 498,069
Less returns and allowances 42,231 5,795
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Net sales 1,034,195 492,274
Cost of sales 70,331 9,411
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Gross profit 963,864 482,863
Operating expenses
Research and development expenses 104,724 150,524
Selling and marketing expenses 471,394 307,629
General and administrative expenses 355,339 583,838
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931,457 1,041,991
------------ ------------
Operating income (loss) before depreciation
and amortization 32,407 (559,128)
Depreciation and amortization expense 352,426 274,172
------------ ------------
Operating income (loss) (320,019) (833,300)
Other income (expense)
Interest expense (51,204) (21,226)
Other - (6,593)
------------ ------------
(51,204) (27,819)
------------ ------------
Net loss before extraordinary item (371,223) (861,119)
Extraordinary item - gain on settlement of debt 527,221 -
------------ ------------
Net income (loss) $ 155,998 $ (861,119)
------------ ------------
------------ ------------
Basic and diluted earnings (loss) per share data
Net loss before extraordinary item $ (0.02) $ (0.06)
Extraordinary item $ 0.02 $ -
------------ ------------
Net income (loss) per share $ 0.01 $ (0.06)
------------ ------------
------------ ------------
Shares used in computing earnings (loss) per share
Basic 21,989,756 15,420,384
------------ ------------
------------ ------------
Diluted 27,471,985 15,420,384
------------ ------------
------------ ------------
</TABLE>
The accompanying notes are an integral part of these statements.
10
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CITADEL COMPUTER SYSTEMS INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
THREE MONTHS ENDED
MAY 31,
1998 1997
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<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $ 155,998 $ (861,119)
Adjustments to reconcile net loss to net cash
used by operating activities
Depreciation and amortization 352,426 274,172
Gain on settlement of debt (527,221) -
Changes in operating assets and liabilities
Accounts receivable (704,760) (93,917)
Notes receivable from related parties (1,613) (92,968)
Other current assets (265,445) (81,942)
Inventories (55,796) -
Bank overdraft (10,249) (167,256)
Accounts payable and accrued expenses 116,576 616,792
Other assets 167,263 (2,032)
Subscription receivable (2,500,000) -
------------ ------------
NET CASH USED BY OPERATING ACTIVITIES (3,272,821) (408,270)
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures (9,369) (133,321)
Development of software (498,503) (145,911)
------------ ------------
NET CASH USED BY INVESTING ACTIVITIES (507,872) (279,232)
CASH FLOW FROM FINANCING ACTIVITIES
Net change in notes payable (76,081) (11,240)
Repayments of long-term debt - (67,280)
Proceeds from the sale of preferred stock 2,701,388 -
Proceed from the sale of equity notes - 695,000
Proceeds from sale of common stock 2,394,400 93,426
------------ ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 5,019,707 709,906
------------ ------------
Net increase (decrease) in cash 1,239,014 22,404
Cash at the beginning of the period 8,555 15,100
------------ ------------
Cash at the end of the period $ 1,247,569 $ 37,504
------------ ------------
------------ ------------
</TABLE>
The accompanying notes are an integral part of these statements.
11
<PAGE>
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A - BASIS OF PRESENTATION
GENERAL:
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, 1998. The balance
sheet as of February 28, 1998 has been derived from the audited financial
statements 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. 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.
RECLASSIFICATIONS:
Certain amounts for the quarter ended May 31, 1997 have been reclassified to
conform to the quarter ended May 31, 1998 presentation.
NOTE B - STOCKHOLDERS' EQUITY
During the period from March 1, 1998 through May 31, 1998, the Company's
stockholders' equity reflected the following changes:
<TABLE>
<S> <C>
Balance at February 28, 1998 $1,287,861
Issuance of preferred stock, net 2,701,388
Conversion of debt to equity 442,500
Issuance of Common Stock, net 2,369,400
Exercise of options 25,000
Net income 155,998
----------
Balance at May 31, 1998 $6,982,147
----------
----------
</TABLE>
NOTE C - COMMITMENTS AND CONTINGENCIES
A former employee of LoneStar (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,
were obligated to pay the exercise price for certain stock options, and
breached a purported agreement to register certain stock held by the
plaintiff. The plaintiff is seeking damages of approximately $2,300,000, plus
attorneys' fees, pre- and post-judgement interest and costs of the lawsuit.
The Company and the individual believe such claims are without merit and
intend to vigorously defend against the claims and are considering filing
counter-claims. The Company has filed an answer in the case, styled HEREDIA
V. CITADEL, ET. AL., in the 298th Court of Dallas County, Texas.
12
<PAGE>
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE C - COMMITMENTS AND CONTINGENICIES CONTINUED
Two former employees of the Company have lawsuits pending against the Company
demanding payment of a promissory note issued in connection with the
acquisition of Kent-Marsh and Astonishing Developments, Inc. and are seeking
damages in excess of $400,000. The Company recently reached a settlement
with one of the employees under the terms of a promissory note and agreed
judgement. The court severed the claims of the remaining party, who amended
his claims to include amounts allegedly owing under an employment agreement
(in the amount of approximately $168,000). The Company believes it has
defenses to payment under the note and employment agreement and intends to
vigorously defend against the lawsuit and pursue counterclaims. The Company
has filed an answer in the case, styled NESBITT & WESOLEK V. CITADEL, in the
193rd District Court of Dallas County, Texas.
On January 7, 1998, the Company's former Houston landlord filed a lawsuit
against the Company, styled LENHNDORFF FOUR OAKS PLACE JOINT VENTURE V.
CITADEL, in the 11th Judicial District Court of Harris County, Texas,
alleging that the Company breached a certain lease covering the Company's
former Houston office space. The suit seeks damages to date of approximately
$180,000, plus attorney's fees, pre- and post-judgment interest and court
costs. The Company believes that it has viable defenses against such a claim
and is in the process of filing a counter-suit against the plaintiff.
The Company and its president are involved in an arbitration proceeding,
styled VESTCOM LTD. V. CITADEL COMPUTER SYSTEMS, INCORPORATED before the
American Arbitration Association in Los Angeles, California. Vestcom claims
it is entitled to compensation and a finder's fee for introducing the Company
to a third party and is seeking damages of $100,000 in shares of the
Company's Common Stock plus 50% of additional consideration paid by the
Company to such a third party. The Company and its president believe they
have defenses to such claim. Vestcom agreed to stay the arbitration
proceeding pending a decision on one of the Company's defenses in Texas state
court. The case is styled CITADEL COMPUTER SYSTEMS, INC. AND STEVEN B.
SOLOMON V. VESTCOM, LTD., in the 193rd Judicial District Court in Dallas
County, Texas. In June 1998, the Texas state court made an oral ruling in
favor of the Company and its president that the purported agreement was a
forgery. In the event the court issues a written opinion in accordance with
its oral ruling, the arbitration proceedings should be permanently enjoined.
The Company intends to vigorously defend against the claim.
On October 12, 1998, five former employees of the Company filed a lawsuit
against the Company and one current and one former officer and director. The
suit alleges that the Company and/or the individuals owe the plaintiffs free
trading stock options in lieu of certain amounts claimed to be due to them
for salary, bonus or override compensation, and seeks damages, attorney's
fees, pre-and post-judgment interest, and costs allegedly in excess of
$4,000,000. The Company and the individuals believe such claims are without
merit and intend to vigorously defend against the claims. The lawsuit is
styled MARKS, MARKS, RANSHAW, COLQUITT & LAURATIS V. CITADEL COMPUTER
SYSTEMS, INC., et al., in the 189th Judicial District Court of Harris County,
Texas.
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.
13
<PAGE>
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE D - CAPITAL TRANSACTIONS
The Company issued 2,253 shares of 11% series D Convertible Redeemable
Preferred Stock during the quarter. The preferred shares are convertible
into Common Stock of the Company at the election of the holders at a
conversion price equal to 150% of the 20 day average of the closing bid price
of the Company's Common Stock prior to the closing of the purchase ($1.075
per share). The Preferred Stock will automatically convert into shares of
Common Stock upon (i) the closing of an underwriting public offering that
values the Company at a minimum equity value of $20,000,000 with proceeds to
the Company of a minimum of $10,000,000 before expenses, or (ii) the date at
which the Company's Common Stock maintains a closing bid price that is 100%
greater than the conversion price for at least 20 consecutive days. Such
shares were not registered under the Securities Act, in reliance upon Section
4(2) of the Securities Act and Rule 506 of Regulation D thereunder. No
underwriters were involved in connection with the sale of the shares under
the Stock Purchase Agreement. Beginning one year from the date of closing,
the Company may redeem all or part of the unconverted preferred shares based
on a redemption price equal to 120% of the issuance price if redeemed prior
to two years after the closing, 115% of the issuance price if redeemed prior
to three years after the closing, or 100% of the issuance price if redeemed
prior to four years after the closing.
The Company also issued 5,000 shares of 6% Series E Convertible Redeemable
Preferred Stock during the quarter. The preferred shares are convertible into
Common Stock of the Company at the election of the holder at any time after
90 days following the date of issuance, at a conversion price equal to the
lesser of (i) seventy-five percent (75%) of the consecutive five-day average
closing bid price for the Company's Common Stock prior to the conversion
date, or (ii) 115% of the closing market price as of the closing date of the
issuance of the Series E Preferred Stock ($.79 per share). At any time after
the date of issuance of the Series E Preferred Stock, and prior to the 90th
day following the date of original issuance, this Company may redeem some or
all of the outstanding Series E Preferred Stock at a redemption price in cash
equal to 107.5% of the original issue price if redeemed within 30 days of
issuance, 112.5% of the original issue price if redeemed between 31 and 60
days of issuance, and 117.5% of the original issue price if redeemed between
61 and 90 days of issuance, plus accrued and unpaid dividends to the
redemption date.
On May 26, 1998, the Company and Icarus Investments I, Ltd. ("Icarus")
entered into a Stock Purchase Agreement pursuant to which Icarus purchased
2,000,000 shares of Citadel's Common Stock for proceeds of $2,500,000. Such
shares were not registered under the Securities Act, in reliance upon
Section 4(2) of the Securities Act and Rule 506 of Regulation D thereunder.
In connection with the transaction, the Company issued warrants to purchase
500,000 shares of the Company's Common Stock at $4.00 per share and 500,000
at $5.00. No underwriters were involved in connection with the sale shares
under the Stock Purchase Agreement. The Company paid an individual a
commission of $175,000 in connection with the transaction.
NOTE E - SUBSEQUENT EVENTS
On June 30, 1998, the Company exercised its 30 - 60 day redemption option
relating to a certain 6% Series E Convertible Redeemable Preferred Stock
issuance and redeemed the 5,000 outstanding shares for $562,500 plus accrued
dividends. The Company thought this was a prudent business decision given
the difference between the Company's current Common Stock market price and
the $.79 conversion price of the issuance.
On June 30, 1998, the Company and Icaurs Investments I, Ltd. ("Icarus")
entered into a Stock Purchase Agreement pursuant to which Icarus purchased
1,000,000 shares of Citadel's Common Stock for proceeds of $1,500,000. Such
shares were not registered under the Securities Act, in reliance upon Section
4(2) of the Securities Act and Rule 506 of Regulation D thereunder. No
underwriters were involved in connection with the sale of the shares under
the Stock Purchase Agreement.
14
<PAGE>
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE F - EARNINGS PER SHARE CALCULATION
<TABLE>
<CAPTION>
FOR THE QUARTER ENDED MAY 31, 1998
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT
---------- ------------- ---------
<S> <C> <C> <C>
Income after extraordinary item $155,998
Less: Preferred stock dividends (18,830)
--------
BASIC EPS
Income available to common
stockholders 137,168 21,989,756 $.01
----
----
EFFECT OF DILUTIVE SECURITIES
Warrants 3,033,565
Convertible preferred stock 18,830 1,771,742
Convertible debt 4,159 676,923
-------- ----------
DILUTED EPS
Income available to common
stockholders + assumed conversions $160,157 27,471,985 $.01
-------- ---------- ----
-------- ---------- ----
</TABLE>
NOTE F - RELATED PARTY TRANSACTIONS
The Company contracted with Metamor Software Solutions, a division of Metamor
Worldwide, Inc. ("Metamor") (formerly CORESTAFF, Inc.) to provide various
development services for the Company. The Company incurred $498,502 in
expenses related to these services during the quarter ended May 31, 1998.
Mr. Johnsen, one of the Company's directors, is executive vice president of
Metamor.
15
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM
FINANCIAL STATEMENTS OF CITADEL TECHNOLOGY, INC. FOR THE QUARTER ENDED
MAY 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL
STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> FEB-28-1999
<PERIOD-START> MAR-01-1998
<PERIOD-END> MAY-31-1998
<CASH> 1,247,569
<SECURITIES> 1,140,375
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 113,308
<CURRENT-ASSETS> 5,716,778
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 10,917,845
<CURRENT-LIABILITIES> 3,860,788
<BONDS> 74,910
0
117
<COMMON> 291,808
<OTHER-SE> 6,690,222
<TOTAL-LIABILITY-AND-EQUITY> 10,917,845
<SALES> 1,034,195
<TOTAL-REVENUES> 1,034,195
<CGS> 70,331
<TOTAL-COSTS> 70,331
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 51,204
<INCOME-PRETAX> 0
<INCOME-TAX> 0
<INCOME-CONTINUING> (371,223)
<DISCONTINUED> 0
<EXTRAORDINARY> 527,221
<CHANGES> 0
<NET-INCOME> 115,998
<EPS-PRIMARY> .01
<EPS-DILUTED> .01
</TABLE>
