<PAGE> 1
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 AUGUST 31, 1999
[ ] 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 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 770, 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.
<TABLE>
<CAPTION>
Class Outstanding at October 18, 1999
- -------------------------------------- -------------------------------
<S> <C>
Common Stock, Par value $.01 per share 43,410,698
</TABLE>
Transitional Small Business Disclosure Format Yes [ ] No [X]
<PAGE> 2
CITADEL TECHNOLOGY, INC.
FORM 10-QSB
FOR THE THREE AND SIX MONTHS ENDED AUGUST 31, 1999
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
<TABLE>
<CAPTION>
Page
----
<S> <C> <C>
Item 1. Financial Statements
Consolidated Balance Sheets
as of August 31, and February 28, 1999....................................................... 3
Consolidated Statements of Operations
for the three and six months ended August 31, 1999 and 1998 ................................. 5
Consolidated Statements of Cash Flow
for the six months ended August 31, 1999 and 1998............................................ 6
Notes to Consolidated Financial Statements ..................................................... 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ......................................................... 10
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................................................... 37
Item 6. Exhibits and Reports on Form 8-K................................................................ 39
Signatures. ............................................................................................ 39
</TABLE>
2
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM I. FINANCIAL STATEMENTS
CITADEL TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
AUGUST 31, FEBRUARY 28,
ASSETS 1999 1999
------------ ------------
(UNAUDITED)
<S> <C> <C>
CURRENT ASSETS
Cash $ 81,045 $ 2,210,377
Accounts receivable, less allowance for returns and
doubtful accounts of $1,058,245 and $1,208,000 781,594 466,288
Notes receivable from related parties 333,934 478,933
Inventory 149,862 148,676
Other 127,921 208,223
------------ ------------
Total current assets 1,474,356 3,512,497
INVESTMENT IN AND ADVANCES TO UNCONSOLIDATED
AFFILIATE 13,250,578 4,458,819
PROPERTY AND EQUIPMENT, net of accumulated
depreciation of $623,751 and $510,051 343,590 386,901
PURCHASED SOFTWARE, net of accumulated amortization
of $2,963,458 and $2,718,486 1,149,734 1,394,706
CAPITALIZED SOFTWARE DEVELOPMENT COSTS,
net of accumulated amortization of $864,849 and $577,000 1,185,877 1,181,052
OTHER ASSETS 407,590 448,372
------------ ------------
$ 17,811,725 $ 11,382,347
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
3
<PAGE> 4
CITADEL TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS - CONTINUED
<TABLE>
<CAPTION>
AUGUST 31, FEBRUARY 28,
LIABILITIES AND STOCKHOLDERS' EQUITY 1999 1999
------------ ------------
(UNAUDITED)
<S> <C> <C>
CURRENT LIABILITIES
Current maturities of long-term debt $ 196,383 $ 311,812
Notes payable 265,333 347,424
Accounts payable and accrued expenses 1,282,228 2,230,859
------------ ------------
Total current liabilities 1,743,944 2,890,095
COMMITMENTS AND CONTINGENCIES -- --
STOCKHOLDERS' EQUITY
Common stock, $.01 par value per share; authorized
60,000,000 shares; issued, 47,336,900 shares
at 8/31/99 and 43,259,274 shares at 2/28/99 473,369 432,592
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 D convertible, 2,000 shares (liquidation value $2,000,000
at 2/28/99) -- 20
Equity notes -- 150,000
Additional paid-in capital 45,255,786 32,835,018
Accumulated deficit (25,578,432) (20,641,875)
Notes receivable for exercise of options/warrants (1,582,704) (1,783,265)
Treasury stock, at cost (4,164,613 shares) (2,500,239) (2,500,239)
------------ ------------
Total stockholders' equity 16,067,781 8,492,252
------------ ------------
$ 17,811,725 $ 11,382,347
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
4
<PAGE> 5
CITADEL TECHNOLOGY, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
AUGUST 31, AUGUST 31,
1999 1998 1999 1998
----------- ------------ ----------- -----------
(UNAUDITED) (UNAUDITED) (UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C>
Net sales $ 901,819 $ 1,077,318 $ 1,102,392 $ 2,111,513
Cost of sales 21,856 60,912 47,777 131,243
----------- ------------ ----------- -----------
Gross profit 879,963 1,016,406 1,054,615 1,980,270
Operating expenses
Research and development expenses 94,287 146,609 244,870 251,333
Selling and marketing expenses 676,449 958,904 1,760,445 1,430,298
General and administrative expenses 214,458 426,152 469,685 781,491
Depreciation and amortization expense 336,316 371,491 658,709 723,917
----------- ------------ ----------- -----------
1,321,510 1,903,156 3,133,709 3,187,039
----------- ------------ ----------- -----------
Operating loss (441,547) (886,750) (2,079,094) (1,206,769)
Other income (expense)
Interest expense (3,642) (30,847) (15,120) (82,051)
Other 9,765 7,566 (3,945) 7,566
Equity in loss of unconsolidated
affiliate (2,242,169) -- (2,598,045) --
----------- ------------ ----------- -----------
(2,236,046) (23,281) (2,617,110) (74,485)
----------- ------------ ----------- -----------
Net loss before extraordinary item (2,677,593) (910,031) (4,696,204) (1,281,254)
Extraordinary item - forgiveness of debt -- 205,847 -- 733,068
----------- ------------ ----------- -----------
Net loss (2,677,593) (704,184) (4,696,204) (548,186)
Preferred stock dividend requirement (9,041) (59,736) (64,493) (79,736)
----------- ------------ ----------- -----------
Net loss allocable to common stockholders $(2,686,634) $ (763,920) $(4,760,697) $ (627,922)
=========== ============ =========== ===========
Basic and diluted loss per share data
Net loss before extraordinary item (0.06) (0.04) (0.11) (0.06)
Extraordinary item -- 0.01 -- 0.03
----------- ------------ ----------- -----------
Net loss per share (0.06) (0.03) (0.11) (0.03)
=========== ============ =========== ===========
Shares used in computing loss per share
Basic and diluted 42,731,355 26,256,753 41,610,994 24,123,254
=========== ============ =========== ===========
</TABLE>
The accompanying notes are an integral part of these statements.
5
<PAGE> 6
CITADEL TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
SIX MONTHS ENDED
AUGUST 31,
1999 1998
------------ ------------
(unaudited) (unaudited)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $ (4,696,204) $ (548,186)
Adjustments to reconcile net loss to net cash
used by operating activities
Depreciation and amortization 658,709 723,917
Equity in loss of unconsolidated affiliate 2,598,045 --
Gain on settlement of debt -- (733,068)
Provision for uncollectible accounts -- 15,000
Changes in operating assets and liabilities
Accounts receivable (315,306) (1,231,007)
Notes receivable from related parties 144,999 (227,113)
Other current assets 80,302 (310,916)
Inventory (1,186) (59,194)
Bank overdraft - (10,249)
Accounts payable and accrued expenses (948,631) (666,132)
Other assets 40,782 112,501
------------ ------------
NET CASH USED BY OPERATING ACTIVITIES (2,438,490) (2,934,447)
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures (82,569) (52,413)
Development of software (292,681) (744,506)
------------ ------------
NET CASH USED BY INVESTING ACTIVITIES (375,250) (796,919)
CASH FLOW FROM FINANCING ACTIVITIES
Net change in notes payable (197,520) (118,219)
Proceeds from sale of preferred stock -- 2,567,391
Proceeds from sale of common stock 881,928 3,772,015
Redemption of preferred stock -- (567,500)
------------ ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 684,408 5,653,687
------------ ------------
Net increase (decrease) in cash (2,129,332) 1,922,321
Cash at the beginning of the period 2,210,377 8,555
------------ ------------
Cash at the end of the period $ 81,045 $ 1,930,876
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
6
<PAGE> 7
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. BASIS OF PRESENTATION
The consolidated financial statements of Citadel Technology, Inc. ("Citadel")
and its majority-owned subsidiaries (collectively, "the "Company") as of August
31, 1999 and for the three and six months August 31, 1999 and August 31, 1998
are unaudited and, in the opinion of management, contain all adjustments,
consisting of only normal recurring items, necessary for the fair presentation
of the financial position and results of operations for the interim period.
These consolidated financial statements should be read in conjunction with the
Consolidated Financial Statements and notes thereto included in the Company's
Form 10-KSB for the year ended February 28, 1999. The results of operations for
the three and six months ended August 31, 1999 are not necessarily indicative of
the results to be expected for the entire year (see "Part II. Item 1.
Management's Discussion and Analysis of Results of Operations and Financial
Condition - Business Risk Factors"). All significant intercompany accounts and
transactions have been eliminated.
On August 9, 1999, the Company's subsidiary How2.com, Inc. ("How2")
completed the acquisition of certain assets of Broadcast Production Group, Inc.
("BPG"). Under the terms of the acquisition agreements, How2 acquired
substantially all of the multimedia production and content conversion assets
from BPG, as well as retaining the services of certain key employees. How2
paid $500,000 in cash and 200,000 (post-split) shares of How2 common stock
with a guaranteed post-split value of $10.00 per share following an initial
public offering, if any. As the result of this acquisition and some additional
private placements during the quarter ended August 31, 1999, the Company's
ownership interest in How2 was reduced to approximately 46%. Therefore, as the
Company's investment in How2 is less than a majority, the Company is using the
equity method to account for its investment in How2 and in connection
therewith the February 28, 19999 financial information has been restated to
account for How2 using such method.
In December 1998, the Company received a comment letter from the Securities and
Exchange Commission with respect to its Form 10-KSB for the fiscal year ended
February 28, 1998 and Quarterly Reports on Form 10-QSB for the periods ended May
31, 1998 and August 31, 1998. The comment letter contained questions relating to
accounting for certain acquisitions, including questions relating to the
write-off of associated in-process research and development costs, and certain
other matters. While the Company has responded to these questions, the Company
cannot determine at this time the effect, if any, that the outcome of this
matter may have on its reported financial position or results of operations. As
a result, it is possible that annual and quarterly financial statements for
fiscal 1998, 1999 and 2000 may need to be restated.
7
<PAGE> 8
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
NOTE 2. CAPITAL TRANSACTIONS
In July 1999, The Company converted the remaining balance of equity notes,
$100,000, plus accrued interest of approximately $15,000 for approximately
76,000 shares of Citadel common stock. The number of shares issued was based on
the conversion price in effect on the dates the notes were converted.
In June 1999, the Metamor Worldwide Inc. ("Metamor") Company converted the
$2,000,000 of Series D preferred stock held by Metamor, plus accrued dividends
of approximately $238,000, into 2,081,937 shares of Citadel common stock.
The Company has previously announced that it will distribute to its shareholders
of record as of March 18, 1999, 750,000 shares (3,000,000 post-split, Note 6.
Subsequent Events) of common stock of How2 upon compliance with Securities and
Exchange Commission ("SEC") requirements applicable to Citadel and How2 in
connection with the proposed spin-off. Following the four-for-one stock split by
How2 in July 1999, Citadel currently anticipates that it stockholders will
receive one share of How2 stock for each 13 shares of Citadel common stock owned
as of the record date. Compliance with SEC requirements and state law could
delay or prevent the completion of the spin-off. There can be no assurances that
Citadel will be able to effect the distribution of the shares of How2 to Citadel
stockholders on a timely basis or at all. In addition, in connection with the
initial public offering of How2, the underwriters will require Citadel, as a
major stockholder of How2, to enter into a lockup agreement that will cause the
spin-off to be commenced 180 days after the initial public offering. Citadel has
agreed to convert certain shares of How2 common stock issued in connection with
certain subscription agreements into shares of Citadel common stock, in the
event How2 does not become publicly traded within one year from the dates of
such agreements. This could result in the issuance of up to 414,000 additional
shares of Citadel common stock at a conversion price of $3.75 per share. In
addition, Citadel has agreed to convert the shares of How2 common stock issued
in connection with the acquisition of 2-Lane Media by How2 into up to 500,000
Citadel shares at the option of the 2-Lane Media shareholders in the event How2
does not become publicly traded by March 2000. These potential issuances would
have the effect of diluting Citadel's stockholders if the market price for
Citadel's common stock is above that price at the time of conversion.
NOTE 3. COMMITMENTS AND CONTINGENCIES
On January 7, 1999, the Company's former Houston landlord filed a lawsuit
against the Company alleging a breach of a lease covering the Company's former
Houston office space. The suit sought damages in excess of $750,000, plus
attorney's fees, pre and post interest and court costs. In July 1999, the
parties reached an agreement in principle to settle the suit for $325,000 to be
paid over nine months.
The Company and its President are involved in an arbitration proceeding with
Vestcom Ltd., a group that claims it is entitled to compensation and a finder's
fee for introducing the Company to a third party. Vestcom Ltd. is seeking
damages of the value of 100,000 shares of the Company's common stock (alleged to
be $1,900,000), plus 50% of additional compensation paid by the Company to such
third party. The Company believes it has defenses to such claims. The Company
and its President filed a declaratory judgment action against Vestcom seeking to
determine that the alleged contract was not valid based on the Company's
defenses. 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 October 1998, the Texas state court entered a judgment and preliminary
injunction in favor of the Company and its president that the purported
agreement was a forgery. As a result, the arbitration proceeding was dismissed
by the American Arbitration Association. The defendant has appealed the decision
of the
8
<PAGE> 9
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
NOTE 3. COMMITMENTS AND CONTINGENCIES, CONTINUED
Texas court. In November 1998, Vestcom filed a lawsuit against the Company in
Texas state court styled Vestcom v. Citadel in the 68th Judicial Court, Dallas
County, Texas, reasserting the same basic claims as in the arbitration
proceeding. The parties held a mediation in September 1999 and were not able to
come to agreement with regards to a settlement, but agreed to continue
settlement discussions.
In August 1998, Janssen Meyers Associates L.P. ("JM") filed a lawsuit against
the Company. The suit alleges that the Company owes the plaintiffs a fee in the
amount of $16,500,000 plus interest and attorney's fees in connection with
services allegedly performed by JM in respect of the merger between LoneStar and
Old Citadel and related matters. The Company believes such claims are without
merit and intends to vigorously defend against the claims. The lawsuit, styled
Janssen Meyers Associates, L.P. v. Citadel Technology, Inc., was filed in the
Supreme Court of the State of New York, County of New York. The Company has
removed the case to federal court in the Southern District of New York.
NOTE 4. INVESTMENT IN UNCONSOLIDATED AFFILIATE
The Company's ownership interest in How2 as of February 28, 1999 was 62%. As of
August 31, 1999 the Company's ownership interest in How2 was 46%. As such, the
Company no longer has a majority ownership interest. The Company accounts for
its ownership interest in How2 using the equity method of accounting. For
comparability purposes, February 28, 1999 information has been restated to
account for the Company's investment in How2 under the equity method of
accounting.
The following is a summary of condensed unaudited financial information
pertaining to How2:
<TABLE>
<CAPTION>
SUMMARIZED BALANCE SHEET AUGUST 31, 1999
- ------------------------ ---------------
<S> <C>
Current assets $ 18,211,366
Other assets 20,162,227
------------
Total assets $ 38,373,593
============
Current liabilities $ 8,043,136
Long-term debt 1,529,293
------------
Total liabilities 9,572,429
------------
Shareholders' equity 28,801,164
------------
$ 38,373,593
============
</TABLE>
<TABLE>
<CAPTION>
3 MONTHS ENDED 6 MONTHS ENDED
SUMMARIZED STATEMENT OF OPERATIONS AUGUST 31, 1999 AUGUST 31, 1999
- ---------------------------------- --------------- ---------------
<S> <C> <C>
Revenues $ 1,275,331 1,766,071
Gross profit 948,102 1,396,611
Operating loss (4,938,712) (5,646,654)
Net loss (4,870,047) (5,561,003)
</TABLE>
9
<PAGE> 10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
THE COMPANY
Citadel Technology, Inc. ("Citadel" or the "Company") and its consolidated
subsidiaries develop and market security and administration software products
for both computer networks and desktop personal computers. Citadel's integrated,
easy-to-use products enable network administrators to control access to network
resources, automate routine network maintenance tasks, and automatically
shutdown and restart servers and desktop PCs in the event of a network crash.
Citadel's products also enable individual PC users to control access to their
desktops, secure files, and index and retrieve files stored in a variety of
storage media. Citadel's software products are designed to reduce the direct and
indirect costs of computer network operations, protect proprietary networks and
information, and otherwise improve overall office productivity. The Company's
Internet subsidiary's Internet and e-commerce services are described below.
NEW PRODUCTS
In August 1999, Citadel completed beta testing and launched its new WinShield
Secure PC product, the next generation WinShield desktop security and
configuration tool. This product provides powerful new Internet security
features that allow Internet filtering and blocking which permit the
administrator to specify the Internet protocols and web sites that are available
for users of the protected computer. Desktop administrators will have the
ability to assign access rights to files and folders for all Windows 95, 98, NT
and Windows 2000 systems. Other new features WinShield Secure PC provides are
security mechanisms such as screen saver control with network authentication,
event management for automatic logoff, as well as timed application usage.
WinShield Secure PC is available for network or stand alone workstations.
10
<PAGE> 11
COMPANY PRODUCT RECOGNITION
In July 1999, the Company announced that Compaq Computer Corporation will
continue to offer Citadel's award-winning WinShield(TM) software with Compaq
computers as part of the Compaq U.S. Education Program. Compaq will provide the
workstation version of WinShield to all education customers who purchase select
Compaq computers as part of the Compaq Education LearningPaq software promotion.
HOW2.COM - PLANNED SPINOFF, ACQUISITIONS AND RELATED MATTERS
In January 1999, Citadel announced that it had formed a subsidiary, How2.com,
Inc. ("How2"), to implement Citadel's Internet and e-commerce strategies. The
How2.com web site initially offers channels including How2Work, How2Play,
How2Home and How2Shop&Save. Citadel received 5 million shares (20,000,000
post-split). Citadel previously announced that it will distribute 750,000 shares
(3,000,000 post split) of How2 common stock owned by Citadel to Citadel's
shareholders of record as of March 18, 1999 upon compliance with the Securities
and Exchange Commission (SEC) requirements applicable to Citadel and How2 in
connection with the proposed spinoff and after the 180 day lockup required by
the underwriters in connection with the initial public offering of How2 (see
Note 2 to Consolidated Financial Statements). The completion of the spinoff
distribution is subject to certain risks and uncertainties including possible
delays related to compliance with the SEC requirements, as to which there can be
no assurances.
11
<PAGE> 12
In July 1999, the Board of Directors of How2 approved a four-for-one stock
split after initial valuation discussions with investment banking firms. The
stock split will be effected as a 300 percent stock dividend to How2
shareholders of record on July 7, 1999. How2 shareholders as of July 7, 1999
(including Citadel) will be issued a certificate representing three additional
shares of common stock for each share of common stock held on the record date.
In August 1999, How2 completed the acquisition of substantially all of the
multimedia production and content conversion (to convert traditional media
formats into web-enabled content) assets from Broadcast Production Group, Inc.
("BPG"). In addition, How2 retained certain members of the BPG management team
as employees of How2. The purchase price consisted of $500,000 in cash and
200,000 post-split shares of How2.com common stock. In connection with the
acquisition, How2 agreed to issue additional shares to the shareholders of BPG
in the event the common stock does not trade at or above $10 in the thirty days
following an initial public offering by How2, if any, based on the average
closing price over the 30 day period.
12
<PAGE> 13
FORWARD-LOOKING STATEMENTS
The following discussion and this Quarterly Report on Form 10-QSB contain
forward-looking statements that involve known and unknown risks, uncertainties
and other factors that may cause our actual results, levels of activity,
performance, or achievements to be materially different from any future results,
levels of activity, performance, or achievements expressed or implied by such
forward-looking statements. Such factors include, among others things, those
risk factors set forth in this section and elsewhere in this report. We identify
forward-looking statements by words such as "may," "will," "should," "could,"
"expects," "plans," "anticipates," "believes," "estimates," "predicts,"
"potential," or "continue" or similar terms that refer to the future. We cannot
guarantee future results, levels of activity, performance or achievements.
Please refer to our annual report on Form 10-KSB for the fiscal year ended
February 28, 1999 and How2's Registration Statement on Form S-1 for further
discussion of these and other risk factors related to the Citadel and its
subsidiaries. The trading price of our common stock could decline due to any of
these risks, and you may lose all or part of your investment.
BUSINESS RISK FACTORS
OUR EARNINGS AND STOCK PRICE ARE SUBJECT TO SIGNIFICANT FLUCTUATIONS. Due to the
factors noted below, our earnings and stock price have been and may continue to
be subject to significant volatility, particularly on a quarterly basis. We have
previously experienced shortfalls in revenue and earnings from levels expected
by investors, which have had an immediate and significant adverse effect on the
trading price of our common stock.
This may occur again in the future.
Additionally, we have received requests from the staff of the Securities and
Exchange Commission for additional information regarding the accounting for
certain of our acquisitions, including questions relating to the write-off of
associated in-process research and development costs and other matters. While we
has responded to these requests, we cannot determine at this time the effect, if
any, that the outcome of this matter will have on our reported financial
position or results of operations. However, should the staff of the Securities
and Exchange Commission require us to retroactively record any adjustments, the
effect could have a material adverse impact on the future trading price of our
common stock.
OUR INDUSTRY IS CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE AND WE WILL NEED TO
ADAPT OUR DEVELOPMENT TO THESE CHANGES. We participate in a highly dynamic
industry characterized by rapid change and uncertainty relating to new and
emerging technologies and markets. The recent trend toward server-based
applications in networks and applications distributed over the Internet could
have a material adverse affect on sales of our products. Future technology or
market changes may cause certain of our products to become obsolete more quickly
than expected.
THE MARKET FOR OUR PRODUCTS IS INTENSELY COMPETITIVE AND WE EXPECT THAT
COMPETITION WILL CONTINUE AND MAY increase. It is influenced by the strategic
direction of major microcomputer hardware manufacturers and operating system
providers. Our competitiveness depends on our ability to enhance existing
products and to offer successful new products on a timely basis. We have limited
resources and must restrict product development efforts to a relatively small
number of projects.
13
<PAGE> 14
INTRODUCTION OF NEW OPERATING SYSTEMS MAY CAUSE SIGNIFICANT FLUCTUATIONS IN OUR
FINANCIAL RESULTS AND STOCK price. If we are unable to successfully and timely
develop products that operate under existing or new operating systems, or if
pending or actual releases of the new operating systems delay the purchase of
our products, our future net revenues and operating results could be materially
adversely affected.
Additionally, as hardware vendors incorporate additional server-based network
management and security tools into network operating systems, the demand may
decrease for some of our products, including those currently under development.
THE TREND TOWARD CONSOLIDATION IN OUR INDUSTRY MAY IMPEDE OUR ABILITY TO COMPETE
EFFECTIVELY. As consolidation in the software industry continues, fewer
companies dominate particular markets, changing the nature of the market and
potentially providing consumers with fewer choices. Also, many of these
companies offer a broader range of products than us, ranging from desktop to
enterprise solutions. We may not be able to compete effectively against these
competitors. Furthermore, we may use strategic acquisitions, as necessary, to
acquire technology, people and products for our overall product strategy. We
have completed a number of acquisitions and dispositions of technologies,
companies and products and may acquire and dispose of other technologies,
companies and products in the future. The trend toward consolidation in our
industry may result in increased competition in acquiring these technologies,
people or products, resulting in increased acquisition costs or the inability to
acquire the desired technologies, people or products. Any of these changes may
have a significant adverse effect on our future revenues and operating results.
WE MUST EFFECTIVELY ADAPT TO CHANGES IN THE DYNAMIC TECHNOLOGICAL ENVIRONMENT OF
THE INTERNET IN A TIMELY MANNER. Critical issues concerning the commercial use
of the Internet, including security, reliability, cost, ease of use,
accessibility, quality of service or potential tax or other government
regulation, remain unresolved and may affect the use of the Internet as a medium
to distribute or support our software products and the functionality of some of
our products. If we are unsuccessful in timely assimilating changes in the
Internet environment into our business operations and product development
efforts, our future net revenues and operating results could be adversely
affected.
WE FACE INTENSE PRICE-BASED COMPETITION FOR SALES OF OUR PRODUCTS. Price
competition is often intense in the software market, especially for utility and
security products. Many of our competitors have significantly reduced the price
of their products. Price competition may continue to increase and become even
more significant in the future, resulting in reduced profit margins.
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THE TRANSITION TO INTEGRATED SUITES OF UTILITIES MAY RESULT IN REDUCED REVENUES.
Citadel and our competitors now provide integrated suites of utility products.
The price of integrated utility suites is significantly less than the aggregate
price of stand-alone products that are included in these utility suites when
sold separately. As a result of the shift to integrated utility suites, price
competition is intense and we have experienced cannibalization of our
stand-alone products that are included within the suite. As a result, there may
be a negative impact on our revenues and operating income from selling
integrated utility suites rather than individual products, as the lower price of
integrated utility suites may not be offset by increases in the total volume of
utility suites sold. Additionally, our products may not compete effectively with
competitors' products or integrated utility suites introduced in the future.
OUR QUARTERLY FINANCIAL RESULTS ARE SUBJECT TO SIGNIFICANT FLUCTUATIONS. We have
been subject to substantial fluctuations in quarterly net revenues, and these
fluctuations may occur in the future. Fluctuations may be caused by a number of
factors, including:
- the timing of announcements and releases of new or enhanced versions
of our products and product upgrades;
- the introduction of competitive products by existing or new
competitors;
- reduced demand for any given product;
- seasonality in the end-of-period buying patterns of foreign and
domestic software markets; and
- the market's transition between operating systems.
Due aforementioned factors, forecasts may not be achieved, either because
expected sales do not occur or because they occur at lower prices or on terms
that are less favorable to us. In addition, these factors increase the chances
that our results could diverge from the expectations of investors and analysts.
WE MAY NOT BE ABLE TO EFFECT THE DISTRIBUTION OF How2 SHARES. In January 1999,
Citadel announced the formation of How2, to implement Citadel's Internet and
e-commerce strategies. Citadel also previously announced that it intends to
distribute 3,000,000 shares of How2 common stock to Citadel's shareholders upon
compliance with the Securities and Exchange Commission (SEC) requirements
applicable to Citadel and How2 in connection with the proposed spinoff and upon
the expiration of a 180 day lockup agreement between Citadel and the underwriter
of How2's proposed initial public offering. Compliance with SEC requirements and
state law requirements could delay or prevent the completion of the spinoff.
There can be no assurances that Citadel will be able to effect the distribution
of the shares of How2 to Citadel shareholders on a timely basis or at all.
In addition, Citadel has agreed to convert the shares of How2 common stock
issued in connection with the acquisition of 2-Lane Media by How2 into up to
500,000 Citadel shares at the option of the 2-Lane Media shareholders in the
event How2 does not become publicly
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traded by March 2000. Pursuant to the terms of the subscription agreements
between How2 and certain of its stockholders, Citadel may be required to issue
up to 414,000 shares of Citadel common stock based on a conversion price of
$3.75 per share (above the fair market value on the dates of issuance) in the
event How2 does not become publicly traded by February 2000. These provisions
could have the effect of diluting Citadel's stockholders if the market price for
Citadel's stock is above that price at the time of conversion.
WE MAY BE UNSUCCESSFUL IN UTILIZING NEW DISTRIBUTION CHANNELS. We currently
offer products over the Internet. We may not be able to effectively adapt our
existing, or adopt new, methods of distributing our software products utilizing
the rapidly evolving Internet and related technologies. The adoption of new
channels may adversely impact existing channels and/or product pricing, which
may reduce our future revenues and profitability.
PRODUCT RETURNS MAY AFFECT OUR NET REVENUES. Product returns can occur when we
introduce upgrades and new versions of products or when distributors or
retailers have excess inventories. Our return policy allows distributors,
subject to various limitations, to return purchased products in exchange for new
products or for credit towards future purchases. End users may return our
products through dealers and distributors within a reasonable period from the
date of purchase for a full refund. In addition, retailers may return older
versions of our products. We estimate and maintain reserves for product returns.
However, future returns could exceed the reserves we have established, which
could have a material adverse affect on our operating results.
OUR INCREASED SALES OF SITE LICENSES MAY INCREASE FLUCTUATIONS IN OUR FINANCIAL
RESULTS AND COULD AFFECT OUR BUSINESS. We sell corporate site licenses through
the distribution channel and through corporate resellers. We are increasingly
emphasizing sales to corporations and small businesses through volume licensing
agreements. These licensing arrangements tend to involve a longer sales cycle
than sales through other distribution channels, require greater investment of
resources in establishing the enterprise relationship and can sometimes result
in lower operating margins. The timing of the execution of volume licenses, or
their non-renewal or re-negotiation by large customers, could cause our results
of operations to vary significantly from quarter to quarter and could have a
material adverse impact on our results of operations. In addition, if the
corporate marketplace grows and becomes a larger component of the overall
marketplace, we may not be successful in expanding our corporate segment to take
advantage of this growth.
WE DEPEND ON DISTRIBUTION BY VALUE ADDED RESELLERS AND INDEPENDENT SOFTWARE
VENDORS FOR A SIGNIFICANT PORTION OF OUR REVENUES. We distribute some of our
products through value added resellers and independent software vendors under
arrangements through which our products are included with these resellers' and
vendors' hardware and software products prior to sale by them through retail
channels. If we are unsuccessful in maintaining our current relationships and
securing license agreements with additional value added resellers and
independent software vendors, or if these resellers and vendors are unsuccessful
in selling their products, our future net revenues and operating results may be
adversely affected.
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THE RESULTS OF OUR RESEARCH AND DEVELOPMENT EFFORTS ARE UNCERTAIN. We believe
that we will need to make significant research and development expenditures to
remain competitive. While we perform extensive usability and beta testing of new
products, the products we are currently developing or may develop in the future
may not be technologically successful. If they are not technologically
successful, our resulting products may not achieve market acceptance and our
products may not compete effectively with products of our competitors currently
in the market or introduced in the future.
THE LENGTH OF THE PRODUCT DEVELOPMENT CYCLE IS DIFFICULT TO PREDICT. The length
of our product development cycle has generally been greater than we originally
expected. We are likely to experience delays in future product development.
These delays could have a material adverse affect on the amount and timing of
future revenues.
WE MUST MANAGE AND RESTRUCTURE OUR OPERATIONS EFFECTIVELY. We continually
evaluate our product and corporate strategy. We have in the past undertaken and
will in the future undertake organizational changes and/or product and marketing
strategy modifications.
These organizational changes increase the risk that objectives will not be met
due to the allocation of valuable limited resources to implement changes.
Further, due to the uncertain nature of any of these undertakings, these efforts
may not be successful and we may not realize any benefit from these efforts.
WE MUST ATTRACT AND RETAIN PERSONNEL WHILE COMPETITION FOR PERSONNEL IN OUR
INDUSTRY IS INTENSE. We believe that our future success will depend in part on
our ability to recruit and retain highly skilled management, marketing and
technical personnel. Competition in recruiting personnel in the software
industry is intense. To accomplish this, we believe that we must provide
personnel with a competitive compensation package, including stock options,
which requires ongoing stockholder approval.
WE RELY ON INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS. We regard our software
as proprietary and underlying technology as proprietary. We seek to protect our
proprietary rights through a combination of confidentiality agreements and
copyright, patent, trademark and trade secret laws. However, we do not employ
technology to prevent copying of our products. Third parties may copy aspects of
our products or otherwise obtain and use our proprietary information without
authorization or develop similar technology independently. The Company does not
have any patents or statutory copyrights on any of its proprietary technology
which the Company believes to be material to its future success, although How2
has filed a provisional patent application with respect to certain of its
business applications and intellectual property rights. In selling its products,
the Company relies primarily on "shrink wrap" licenses that are not signed by
licensees, and, therefore, such licenses may be unenforceable under the laws of
certain jurisdictions. In addition, existing copyright laws afford limited
practical protection. Furthermore, the laws of some foreign countries do not
offer the same level of protection of our proprietary rights as the laws of the
United States. There can be no assurance that the Company's means of protecting
its proprietary rights will be adequate or that the Company's competitors will
not independently develop similar technology substantially equivalent or
superseding
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proprietary technology. Furthermore, there can be no assurance that any
confidentiality agreements between the Company and its employees will provide
meaningful protection of the Company's proprietary information, in the event of
any unauthorized use or disclosure thereof. Any legal action that we may bring
to protect proprietary information could be expensive and may distract
management from day-to-day operations.
WE ARE INVOLVED IN LITIGATION WHICH COULD, AND ANY FUTURE LITIGATION MAY, AFFECT
OUR FINANCIAL RESULTS. From time to time, we may be subject to claims that we
have infringed the intellectual property rights of others, that our products are
not Year 2000 compliant or other product liability claims, or other claims
incidental to our business. We are involved in a number of judicial and
administrative proceedings incidental to our business. For a discussion of our
current litigation, see Part II, Item 1. Legal Proceedings and the Notes to
Consolidated Financial Statements in this Form 10-QSB. We intend to defend
and/or pursue all of these lawsuits vigorously. We may suffer an unfavorable
outcome in one or more of the cases. We do not expect the final resolution of
these lawsuits to have a material adverse effect on our financial position,
individually or in the aggregate. However, depending on the amount and timing of
unfavorable resolutions of these lawsuits, or the costs of settlement or
litigation, our future results of operations or cash flows could be materially
adversely affected in a particular period.
Year 2000 - Product Liability Litigation
We believe the software products that we currently develop and actively market
are Year 2000 compliant for significantly all functionality. However, these
products could contain errors or defects related to the Year 2000. In addition,
earlier versions of our products, those that are not the most currently released
or are not currently being developed, may not be Year 2000 compliant. We have
sold some of our older products, which are not being actively developed and
updated. These older products are also not necessarily Year 2000 compliant and
are no longer sold by us.
Software Defects and Product Liability
Software products frequently contain errors or defects, especially when first
introduced or when new versions or enhancements are released. For example, in
the past, our anti-virus software products have incorrectly detected viruses
that do not exist. We have not experienced any material adverse effects
resulting from any of these defects or errors to date and we test our products
prior to release. Nonetheless, defects and errors could be found in current
versions of our products, future upgrades to current products or newly developed
and released products. Software defects could result in delays in market
acceptance or unexpected reprogramming costs, which could materially adversely
affect our operating results. Most of our license agreements with customers
contain provisions designed to limit our exposure to potential product liability
claims. It is possible, however, that these provisions limiting our liability
may not be valid as a result of federal, state, local or foreign laws or
ordinances or unfavorable judicial decisions. A successful product liability
claim could have a material adverse affect on our business, operating results
and financial condition.
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OUR SOFTWARE PRODUCTS AND WEB SITE MAY BE SUBJECT TO INTENTIONAL DISRUPTION.
While we have not been the target of software viruses specifically designed to
impede the performance of our products, such viruses could be created and
deployed against our products in the future. Similarly, experienced computer
programmers, or hackers, may attempt to penetrate our network security or the
security of our web site from time to time. A hacker who penetrates our network
or web site could misappropriate proprietary information or cause interruptions
of our services. We might be required to expend significant capital and
resources to protect against, or to alleviate, problems caused by virus creators
and hackers.
WE MAY EXPERIENCE REDUCED DEMAND FOR OUR PRODUCTS DUE TO CHANGES IN CUSTOMER
BEHAVIOR RESULTING FROM YEAR 2000 PREPARATION. With the emerging requirements on
Year 2000 compliance and functionality, many enterprise customers may use their
Information Technology budgets in 1999 to focus on Year 2000 issues. In
addition, our customer's Information Technology organizations may be unwilling
to deploy new software until after the Year 2000 in order to reduce the
complexity of any changes in their systems required by any actual Year 2000
failures. Either of these factors could reduce sales of our products and could
have an adverse affect on revenues. In addition, we may experience significantly
reduced revenues from our Norton 2000 product sales as demand may significantly
decline and could adversely affect our future operating results.
WE MAY EXPERIENCE DISRUPTION OF OUR INTERNAL SYSTEMS AS A RESULT OF THE YEAR
2000. Many currently installed computer systems and software products include
coding to accept only two digit entries in the date code field. These date code
fields will need to accept four digit entries to distinguish 21st century dates
from 20th century dates. Systems that do not properly recognize such information
could generate erroneous data or cause a system to fail. Significant uncertainty
exists in the software industry concerning the potential effects associated with
such problems.
The Company has conducted Year 2000 compliance reviews for its internal systems.
The review is comprised of four phases: (i) assessment of all of the Company's
systems and technology; (ii) remediation; (iii) implementation and testing of
modifications to or replacements of existing systems and technology; and (iv)
contingency planning.
Failures of our internal software and hardware systems contain all the necessary
software routines and programs for the accurate calculation, display, storage
and manipulation of data involving dates would seriously harm our business,
operating results and financial condition.
The Company has initiated communication with key business partners to determine
the extent to which the Company is vulnerable to those third parties potential
failure to remediate their own Year 2000 issues. Additionally, the Company has
identified it critical suppliers and is in the process of requesting Year 2000
compliance documentation from these suppliers respecting their products,
services and supply chain.
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The Company believes the software and hardware it uses internally complies with
Year 2000 requirements. However, serious, unanticipated negative consequences,
including material costs caused by undetected errors or defects in the
technology used in our internal systems may occur. The occurrence of any of the
foregoing could seriously harm our business, operating results or financial
condition.
The Company has funded its Year 2000 compliance review from operating cash flows
and has not separately accounted for these costs in the past. To date the
Company has not incurred material costs in addressing Year 2000 issues, and does
not anticipate incurring material costs in implementing its Year 2000 plan or
developing Year 2000 contingency plans. However, there can be no assurances that
the actual costs of implementing the Company's Year 2000 plan will exceed the
Company's estimates or that the Company's business will not be materially
adversely affected by Year 2000 issues.
WE MAY NEED ADDITIONAL FINANCING. The Company currently funds product
development and sales and marketing activities through existing cash reserves
and cash from operations and issuances of securities. In the event that cash
from operations and other available funds prove to be insufficient to fund the
Company's presently anticipated operations, the Company will be required to seek
additional financing. There can be no assurance that, if additional financing is
required, it will be available on acceptable terms, or at all. Additional
financing may involve substantial dilution to the interests of the Company's
then-current shareholders.
ADDITIONAL RISKS RELATED TO OUR INTERNET SUBSIDIARY, HOW2.COM.
The following are certain risks related to the business of How2.com, our
Internet subsidiary, and should be considered in addition to the risk factors
described above. Any of these factors could have a material adverse effect on
Citadel, its results of operations, its financial condition and the market price
of its common stock. References to "we," "our," or "us" in these risk factors
refers to How2.com.
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OUR BUSINESS AND FUTURE PROSPECTS ARE EXTREMELY DIFFICULT TO EVALUATE BECAUSE
OUR OPERATING HISTORY IS VERY LIMITED.
Our company was formed in January 1999. We acquired our rebates operation
in May 1999. Our online marketplace began initial operations in September 1999.
As a result, we have only a limited operating history on which you can base an
investment decision. You should consider our prospects in light of the
uncertainties and difficulties frequently encountered by companies in their
early stages of development. These risks are heightened in new and rapidly
evolving industries such as e-commerce, and are further heightened by our use of
an unproven Business-to-Business-to-Consumer, or B2B2C, business model. To
address these risks and uncertainties, we must, among other things:
- develop and enhance our brand, and expand our tutorial content and
product and service offerings;
- establish and sustain e-commerce relationships with manufacturers,
retailers, service providers and content providers;
- generate revenues from multiple new sources, including e-commerce,
sponsorships, data mining services, extended warranty sales, content
conversion and online training services; and
- continue to develop and upgrade our technology infrastructure to support
our operations and the growth of our online marketplace.
We cannot assure you that our online digital marketplace concept will
receive market acceptance or that consumers, once on our site, will buy products
through our online marketplace. We expect to derive all of our long-term future
revenue from our online marketplace. Our online marketplace has produced only
minimal revenues and is not yet profitable. If we are unable to establish
pricing and revenue models acceptable to consumers, our e-seekers, and
manufacturers, retailers, service organizations and content providers, or our
e-partners, our online service may not be commercially successful.
We may not successfully accomplish any of our objectives. If we do not
successfully address these risks, our business would be materially adversely
affected.
WE HAVE A HISTORY OF NET LOSSES AND EXPECT TO CONTINUE TO INCUR SUBSTANTIAL NET
LOSSES IN THE FUTURE.
We had a net loss and an accumulated deficit of approximately $2.2 million
for the period from our inception through June 30, 1999. We expect to incur
substantial operating losses for the foreseeable future. We may not have any
revenue growth in the future, and our revenues could decline. Moreover, we
expect to significantly increase our sales and marketing expenses as well as
general and administrative expenses. Over the longer term, we expect to derive a
substantial portion of our revenues from our non-rebate online services, but
these services are based on an unproven business model. As a consequence, we may
never be profitable.
WE ARE DEPENDENT ON STAPLES AND ITS VENDORS FOR A SUBSTANTIAL PORTION OF OUR
BUSINESS.
We are dependent upon our relationship with Staples and its vendors who
choose to participate in our online rebate services for a substantial portion of
our existing and anticipated revenues. We expect that we will continue to be
dependent upon Staples and its vendors for a significant portion of our revenues
in future periods. As a result of this concentration of sales, our business,
operating results or financial condition would suffer as a result of the
termination of or adverse change in our relationship with Staples
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or any of its material vendors. In addition, we cannot assure you that our
relationship with Staples and its vendors will continue, or if continued, will
increase in any future period. The initial term of our agreement with Staples
expires in July 2000. The agreement is renewable annually upon mutual agreement
between Staples and us. In addition, Staples' vendors may not use, or may
discontinue their use of, our rebate and related services. Therefore, we cannot
assure you that we will generate significant revenues in future periods from
Staples or its vendors. The loss of all or any part of our relationship with
Staples or its vendors would seriously harm our business.
OUR QUARTERLY OPERATING RESULTS WILL LIKELY VARY SIGNIFICANTLY IN THE FUTURE.
We expect that our revenues and operating results may vary significantly
from quarter to quarter. As a result, quarter-to-quarter comparisons of our
results of operations may not be meaningful. In some future quarter or quarters,
our operating results are likely to fall below expectations. Any shortfall will
likely adversely affect the price of our common stock, if it becomes publicly -
traded in a manner that may be unrelated to our long-term operating performance.
Our quarterly operating results, as well as our operating results
generally, may also vary depending on a number of other factors, including but
not limited to:
- demand for our rebate and related services and our other Internet
services;
- fluctuations in the average face amount of the rebates we process;
- seasonality in manufacturers' promotions that involve rebates;
- actions taken by our competitors, including new product introductions and
enhancements, or entry of new competitors into our markets;
- our ability to scale our network and operations to attract and support
large numbers of e-seekers (or consumers), e-partners (manufacturers,
retailers, service organizations and content providers) and
transactions;
- our ability to develop, introduce and market new products and services
and enhancements to our existing products and services on a timely basis;
- changes in our pricing policies or those of our competitors;
- our ability to expand our sales and marketing operations, including
hiring additional sales personnel;
- size and timing of sales of our products and services;
- success in maintaining and enhancing our existing relationship with
Staples, Staples' vendors and our other e-partners, and developing new
relationships with additional e-partners;
- compensation policies that reward sales personnel based on achieving
quotas;
- our inability to control costs and fluctuations in operating expenses;
- technological changes in our markets;
- timing of new e-partner alliances;
- changes in accounting standards and revenue recognition policies;
- e-partner budget cycles and changes in those budget cycles;
- amortization of goodwill and other intangibles;
- seasonality of Internet use; and
- general economic conditions.
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In addition, because our increasing expense levels are based in part on
expectations of our future revenues, any decline in our revenues below our
expectations would have a disproportionately adverse impact on our operating
results.
OUR REBATE AND RELATED SERVICES HAVE ACCOUNTED FOR SUBSTANTIALLY ALL OF OUR
REVENUES SINCE INCEPTION, AND WE EXPECT TO DEPEND ON OUR REBATE AND RELATED
SERVICES FOR A SIGNIFICANT PORTION OF OUR REVENUES FOR THE FORESEEABLE FUTURE.
Our rebate and related services accounted for substantially all of our
revenues since inception. We anticipate that revenues from our rebate and
related services will continue to constitute a significant portion of our
revenues for the foreseeable future. Consequently, a decline in the demand for
our rebate and related services, or failure to achieve broad market acceptance
of our rebate services, would seriously harm our business. In addition, a
decrease in the amount of promotional dollars spent on rebate programs by our
e-partners would negatively impact our results of operations.
We bill our rebate e-partners for the full amount of the rebate checks that
we issue to consumers, plus a processing fee. However, some consumers never cash
these rebate checks. In the rebate industry, uncashed checks are referred as
"slippage." Slippage is recorded on our books as an increase to net revenues.
For the period from January 7, 1999 to June 30, 1999, our net revenues included
$269,000 of slippage, representing 47.4% of our net revenues for the period. Our
operating results could suffer if the slippage percentage decreases or if any
state is entitled to the slippage amounts as a result of its unclaimed property
or escheat laws. Furthermore, we expect that more consumers will cash their
rebate checks as a result of our online rebate process, which will further
reduce slippage. In addition, a decline in the amount of slippage that we retain
or a decrease in the rebate service fees we receive could decrease our net
revenues and negatively impact our results of operations.
WE WILL NEED TO RAISE ADDITIONAL CAPITAL, AND THIS CAPITAL MAY NOT BE AVAILABLE
ON ACCEPTABLE TERMS, IF AT ALL.
We will need to raise additional funds. There can be no guarantee that our
proposed initial public offering will be completed. In addition, we may need to
raise additional funds in order to take advantage of new business opportunities,
to react to unforeseen difficulties or to otherwise respond to pressures from
our competitors. We cannot assure you that we will be able to obtain additional
financing on favorable terms, if at all. If we cannot raise funds on acceptable
terms, if and when needed, our business will suffer.
OUR BRAND MAY NOT ACHIEVE THE BROAD RECOGNITION AND LOYALTY NECESSARY TO
SUCCEED.
We believe that broad recognition and favorable consumer perception of the
How2.com brand are essential to our future success. Accordingly, we are pursuing
an aggressive brand-enhancement strategy, which includes mass market and
multimedia advertising, promotional programs and public relations activities.
Successful positioning of our How2.com brand will largely depend upon:
- the success of our marketing, public relations and promotional efforts;
- the quantity and quality of our tutorial content;
- the technical performance and visual appearance of our online
marketplace; and
- our ability to provide high quality customer service, including online
and offline responses to customer inquiries regarding the status of their
rebates.
To increase awareness of the How2.com brand we will spend significant
amounts on marketing and promotions. These expenditures may not result in a
sufficient increase in net revenues to cover these marketing and promotion
expenses. In addition, even if brand recognition increases, the number of new e-
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seekers or the number of transactions on our online marketplace may not
increase. Also, even if the number of new e-seekers increases, those e-seekers
may not use our online marketplace on a regular basis.
WE DEPEND UPON STRATEGIC ALLIANCES TO DEVELOP CONTENT, CONDUCT E-COMMERCE, SELL
PRODUCTS AND IMPLEMENT OUR TECHNOLOGY SOLUTIONS.
We depend upon third parties for several critical elements of our business,
including content development, e-commerce sales and technology.
Content Development
The tutorial information on our online marketplace, or content, is
available for license from a limited number of resources. While currently less
than 20% of our tutorials are licensed from outside sources, we plan to increase
the amount of content we acquire from third-party sources in the future. In
addition, we rely on content licensed from third parties for other features
appearing on our online marketplace, such as news feeds, stock information and
horoscopes. If we are unable to successfully retain our currently licensed
content or negotiate license agreements with suitable content providers, we will
be required to develop all of our content internally and there can be no
assurance that we will be able to develop adequate quantity or quality of these
tutorials on our own.
e-Partners
Our ability to conduct e-commerce depends on our ability to successfully
enter into relationships with manufacturers, service organizations, retailers
and content providers that wish to distribute their products and services
through our online marketplace. We currently have strategic relationships with
only a limited number of e-partners. We anticipate that our distribution
arrangements will typically not be exclusive and will be subject to termination
upon short notice. In addition, we cannot assure you that these arrangements
will result in revenues or be profitable for us.
Technology
We have entered into material contracts with third parties, and plan to
continue to enter into material contracts with third parties, to manage,
maintain and expand the computer and communications equipment and software
needed for the day-to-day operations of our business.
These third parties provide important services to us, including the
following:
- managing the web server for our online marketplace;
- maintaining our communications lines;
- managing the network data centers where our network data is stored; and
- integrating and testing the compatibility of each web page on our online
marketplace.
If these third parties do not perform to our requirements, we would have to
obtain similar services from another provider or perform these functions
ourselves. We may not be able to successfully obtain or perform these services
on a timely and cost-effective basis. Due to the third party installation of the
computers, communications equipment and software needed for the day-to-day
operations of our online marketplace, we may be entirely dependent on that party
to manage, maintain and provide security for this technology. Any termination or
breach of these contracts could have a material adverse effect on our business.
IN ORDER TO MANAGE OUR GROWTH AND EXPANSION, WE WILL NEED TO IMPROVE AND
IMPLEMENT NEW SYSTEMS, PROCEDURES AND CONTROLS.
Since our formation, we have experienced significant expansion of our
operations. This expansion has placed a strain upon our management systems and
other resources. If we are unable to manage our growth
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and expansion, our business will be materially adversely affected. In addition,
we have recently hired a significant number of employees and plan to further
increase our total headcount. This expansion will continue to place substantial
demands on our management systems and other resources. Our ability to compete
effectively and to manage future expansion of our operations, if any, will
require us to continue to improve our financial and management controls,
reporting systems and procedures as well as expand, train and manage our
employee work force.
ADOPTION AND INTEGRATION OF OUR PRODUCTS AND SERVICES BY LARGE E-PARTNERS IS
COMPLEX, TIME CONSUMING AND EXPENSIVE.
We recruit e-partners to process their rebates, sponsor content and sell
goods and services on our online marketplace. The adoption and integration of
our products and services by large organizations is complex, time consuming and
expensive. In many cases, our e-partners must change established business
practices and conduct business in new ways. In addition, they must generally
consider a wide range of other issues before committing to use our services,
including benefits, ease of use, ability to work with existing systems,
functionality and reliability. Furthermore, we must educate potential e-partners
on the use and benefits of our services. In addition, we believe that the
purchase of our services is often discretionary. It frequently takes several
months to develop an e-partner relationship and requires approval at a number of
management levels within the e-partners' organization. These long cycles may
cause delays in our sales and we may spend a large amount of time and resources
on potential e-partners who decide not to use our services, which could
materially and adversely affect our business.
IF WE LOSE OUR KEY PERSONNEL OR CANNOT RECRUIT ADDITIONAL PERSONNEL, OUR
BUSINESS MAY SUFFER.
Since our formation, we have expanded from one employee to more than 180
employees. We also have employed many key personnel since our formation,
including Steven B. Solomon, our Chairman and Chief Executive Officer, Kenneth
R. Johnsen, our President and Chief Operating Officer, Juli C. Spottiswood, our
Chief Financial Officer and Corporate Secretary, Andrew F. Adams, our Chief
Technology Officer, Allan J. Steinmetz, our Executive Vice President of
Marketing Strategy, Kelly R. Melvin, our Director of Infrastructure Design and
Architecture, Mason Wright, our Director of Internet Platforms and Engineering,
and other key managerial, marketing, planning, financial, technical and
operations personnel. We expect to continue to add additional key personnel in
the near future. We do not have "key person" life insurance policies on any of
our key personnel. Our business could be negatively impacted if we were to lose
the services of one or more of these persons.
OUR BUSINESS IS VERY LABOR INTENSIVE AND, AS A RESULT, WE ARE DEPENDENT ON OUR
EMPLOYEE BASE.
Our future success depends on our continuing ability to attract, hire,
train and retain a substantial number of highly skilled managerial, creative,
technical, sales, marketing, research and customer support personnel. In
addition, we will need to add a significant number of new technical support and
operations personnel to support the operations of our online marketplace and our
rebate and related services. Competition for qualified personnel is intense, and
we may fail to attract or retain these personnel, in which case our business
would be negatively impacted.
Because labor costs are a significant portion of our costs, an increase in
wages, costs of employee benefits or employment taxes could seriously harm our
business. In addition, our facilities are located in areas, including Dallas,
Los Angeles, Silicon Valley and Seattle, with a high demand for technical and
other personnel and relatively low unemployment rates. It is more difficult and
costly to hire qualified personnel in these areas.
OUR MARKETS ARE HIGHLY COMPETITIVE.
The rebate and fulfillment industry is highly competitive and fragmented.
We expect competition to persist and to intensify in the future. Our competitors
include small firms offering specific promotion fulfillment applications,
divisions of larger entities and large independent firms, such as Young America
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Corporation and Continental Promotions Group. A number of competitors have or
may develop greater capabilities and resources than us. Similarly, additional
competitors with greater resources than us may enter the online rebate and
fulfillment industry. Our performance and growth could be negatively affected if
our existing or potential rebate e-partners decide to perform their own rebate
operations that are currently outsourced or use another provider. In addition,
competitive pressures from current or future competitors could cause our
services to lose market acceptance or result in significant price erosion. This
could result in a material adverse effect upon our business.
The market for our Internet tutorial, e-commerce, content conversion
services and corporate training is also intensely competitive, evolving and
subject to rapid technological change. We expect the intensity of competition to
increase in the future. Increased competition is likely to result in price
reductions, reduced gross margins and loss of market share, any one of which
could seriously harm our business. Our competitors vary in size and in the scope
and breadth of the products and services offered. We primarily encounter
competition with respect to different aspects of our business from tutorial,
corporate training, content conversion services and e-commerce from companies
such as Learn2.com, Inc. and eHow, Inc., as well as from Internet portals,
search engines and specific interest sites offered by companies such as Ask
Jeeves, Inc., Yahoo! Inc., Snap! LLC, Martha Stewart Living Omnimedia, LLC,
About.com, Inc., iVillage, Inc. and VerticalNet, Inc. In addition, we experience
competition from numerous sites doing e-commerce, such as Amazon.com, Inc.,
BuyItNow.com, L.L.C. and Xoom.com, Inc. Moreover, because there are low barriers
to entry in our markets, we expect additional competition from other established
and emerging companies, as the markets continue to develop and expand.
Many of our current and potential competitors have longer operating
histories, significantly greater financial, technical, marketing, production and
other resources. In addition, some have significantly greater name recognition
and a larger existing base of customers, and many have well-established
relationships with our current and potential e-partners and have extensive
knowledge of our industry. Our current and potential competitors have
established or may establish cooperative relationships among themselves or with
third parties to increase the ability of their products to address customer
needs. Accordingly, it is possible that new competitors or alliances among
competitors may emerge and rapidly acquire significant market share. We also
expect that competition will increase as a result of industry consolidations. In
the event a larger company acquires one or more of our competitors, we would
face increased competition.
WE MAY NEED TO CONTINUE TO MAKE ACQUISITIONS IN ORDER TO REMAIN COMPETITIVE IN
OUR MARKET. OUR BUSINESS COULD BE ADVERSELY AFFECTED AS A RESULT OF ANY OF THESE
FUTURE ACQUISITIONS.
In order to obtain content, complementary technologies or other resources,
or to otherwise remain competitive, we may find it necessary to acquire
additional businesses, products, technologies, expertise or other resources. We
may not be able to identify suitable acquisition candidates. Even if we identify
an appropriate acquisition candidate, we may not be able to negotiate the terms
of the acquisition successfully, finance the acquisition or integrate the
acquired business, products, technologies, expertise or other resources into our
existing business and operations. Further, completing a potential acquisition
and integrating the acquired businesses or resources will cause significant
diversions of management time and resources. In addition to the acquisitions we
have completed to date, if we consummate one or more additional significant
acquisitions in which the consideration consists of stock or other equity
securities, our stockholders' ownership could be significantly diluted. If we
were to proceed with one or more significant acquisitions in which the
consideration includes cash, we could have to use a substantial portion of our
available cash to consummate these acquisitions. Acquisition financing may not
be available on favorable terms, or at all. In addition, we may be required to
amortize significant amounts of goodwill and other intangible assets in
connection with past and future acquisitions, which would adversely affect our
results of operations.
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WE FACE POTENTIAL CONFLICTS OF INTERESTS RELATING TO CITADEL.
Because of our relationship with Citadel, which owns a substantial portion
of our common stock, and our interlocking directors, officers and stockholders,
we are likely to face potential conflicts of interest relating to Citadel.
Executives, employees and consultants associated with Citadel assisted in
the development of our business model. Steven B. Solomon is the Chief Executive
Officer and President of Citadel as well as founder, Chairman and Chief
Executive Officer of How2.com. In addition, Kenneth R. Johnsen, our President
and Chief Operating Officer, Lawrence Lacerte, Victor K. Kiam II, Mark Rogers,
Chris A. Economou and Edward A. Pierce serve as directors of both Citadel and
our company. Prior to or upon completion of the proposed initial public
offering, Messrs. Johnsen, Kiam, Rogers and Economou intend to resign from the
Citadel board of directors.
Certain of our executive officers, key employees and directors also
beneficially own, or hold options or warrants to purchase, approximately 33.0%
of the outstanding common stock of Citadel as of September 30, 1999. Steven B.
Solomon owned approximately 13.0% of Citadel's common stock as of September 30,
1999. Accordingly, conflicts of interest may arise from time to time between us
and Citadel, particularly with respect to the pursuit of overlapping business
opportunities. We have not adopted any formal plan or arrangement to address
these potential conflicts of interest and intend to review related-party
transactions with Citadel on a case-by-case basis.
Because we have interlocking directors and officers with Citadel, there may
be inherent conflicts of interest when these directors and officers make
decisions related to transactions between us and Citadel. Directors may be
required to abstain from voting with respect to matters involving both Citadel
and our company. We may lose valuable management input from these directors and
officers who have conflicts.
WE MAY BE SUED FOR INFORMATION RETRIEVED FROM OUR ONLINE MARKETPLACE OR FOR
PRODUCTS AND SERVICES OFFERED THROUGH OUR ONLINE MARKETPLACE.
We may be subject to claims for defamation, negligence, copyright or
trademark infringement, personal injury or other legal theories relating to the
information we publish on our online marketplace. These types of claims have
been brought, sometimes successfully, against online services, as well as print
publications, in the past. We could also be subjected to claims based upon the
content that is accessible from our online marketplace through links to other
web sites or through content and materials that members may post in our chat
rooms or on our bulletin boards. Our insurance, which covers commercial general
liability, may not adequately protect us against these types of claims. In
addition to monetary damages, any such claims could harm our reputation and
public image, causing serious harm to our business.
In addition, consumers may sue us if any of the products or services that
we or our e-partners sell online are defective, fail to perform properly or
injure the user. To date, we have had limited experience in the sale of products
online. We plan to develop relationships with our e-partners to offer a range of
products targeted specifically at the interests of our e-seekers, as
demonstrated by their viewing of related tutorials. This strategy involves
numerous risks and uncertainties. Any errors, defects or other performance
problems could result in financial or other damage to our e-seekers. A product
liability or other claim brought against us, even if not successful, would
likely be time consuming and costly and could seriously harm our business.
Liability claims could require us to spend significant time and money in
litigation or to pay significant damages. As a result, any of these claims,
whether or not successful, could seriously damage our reputation and our
business.
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IF THE PROTECTION OF OUR INTELLECTUAL PROPERTY IS INADEQUATE, OUR COMPETITORS
MAY GAIN ACCESS TO OUR CONTENT AND TECHNOLOGY.
We depend on our ability to develop and maintain the proprietary aspects of
our content and technology. To protect our proprietary content and technology,
we rely primarily on a combination of contractual provisions, confidentiality
procedures, trade secrets and patent, copyright and trademark laws.
We seek to avoid disclosure of our trade secrets through a number of means
including, but not limited to, requiring those persons with access to our
proprietary information to execute confidentiality agreements and restricting
access to our source codes. We seek to protect our content, software,
documentation and other written materials under trade secret and copyright laws,
which afford only limited protection. We cannot assure you that any of our
proprietary rights with respect to our services will be viable or of value in
the future because the validity, enforceability and type of protection of
proprietary rights in Internet-related industries are uncertain and still
evolving.
Although we have filed a provisional patent application with respect to our
proprietary online rebate systems and processes, we have not conducted searches
regarding the patentability of our application. We have no patents, and may not
receive a patent related to our proprietary online rebate applications. If we
receive a patent related to our proprietary rebate application, we may be unable
to claim the filing date of, and priority from our existing provisional patent
application. Our future patents, if any, may be successfully challenged,
rendering them invalid or unenforceable, or may not provide us with any
competitive advantages. We may not develop proprietary products or technologies
that are patentable and other parties may have prior claims. Additionally, other
parties may have equal rights to any patents issued to us, through claims of
inventorship or otherwise, and, if so, would be able to use the patented
technology or license it to others without our consent. The validity and
enforceability of our future patents, if any, may also be affected by future
legislative actions or judicial decisions, especially to the extent such future
patents may be deemed "method of doing business" patents.
Although we have filed trademark applications with respect to various
trademarks that we are using in connection with our business, we have not
conducted extensive searches regarding the availability of those trademarks. We
have received no trademark registrations, and may not receive any trademarks
from our filed trademark applications. Our trademarks may be successfully
challenged or may not provide us with any competitive advantages. None of our
trademarks may be registrable and other parties may have priority of use of such
trademarks or variants thereof.
We obtain our content from a number of sources for our tutorials. Our
efforts in securing rights to all of our content may be insufficient and, as a
result, we may be subject to claims of copyright infringement.
Despite our efforts to protect our proprietary rights, unauthorized parties
may attempt to copy aspects of our content and other intellectual property or to
obtain and use information that we regard as proprietary. Policing unauthorized
use of our products is difficult, and while we are unable to determine the
extent to which piracy of our content or other intellectual property exists,
content piracy can be expected to be a persistent problem. In addition, the laws
of some foreign countries do not protect our proprietary rights as much as do
the laws of the United States. Our means of protecting our proprietary rights
may not be adequate and our competitors may independently develop similar
technology, duplicate our products or design around patents issued to us or our
content or other intellectual property.
There has been a substantial amount of litigation in the Internet industry
regarding intellectual property rights. It is possible that in the future third
parties may claim that we or our current or potential future content, products
or services infringe upon their intellectual property. We expect that developers
and providers of e-commerce solutions will increasingly be subject to
infringement claims as the number of products and competitors in this industry
segment grows and the functionality of products in different industry segments
overlaps. Any claims, with or without merit, could be time-consuming, result in
costly litigation, cause delays in implementation of our services or require us
to enter into royalty or licensing agreements. Royalty or licensing agreements,
if required, may not be available on terms acceptable to us, which could
seriously harm our business.
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WE ARE DEPENDENT ON OUR DOMAIN NAMES, AND WE COULD SUFFER LOSSES IF OUR DOMAIN
NAMES ARE NOT PROTECTED.
We currently own and control the Internet domain names "www.how2.com" and
"www.how2hq.com" as well as various other related names. Domain names generally
are regulated by international Internet regulatory bodies. The regulation of
domain names in the United States and in foreign countries is subject to change.
Regulatory bodies could establish additional top-level domains, appoint
additional domain name registrars or modify the requirements for holding domain
names. As a result, we may not acquire or maintain the "www.how2.com" and
"www.how2hq.com" domain names in all of the countries in which we conduct
business.
The relationship between regulations governing domain names and laws
protecting trademarks and similar proprietary rights is unclear. Therefore, we
may be unable to prevent third parties from acquiring or using domain names that
infringe or otherwise decrease the value of our trademarks and other proprietary
rights.
OUR BUSINESS COULD BE ADVERSELY AFFECTED IF THE SYSTEMS WE OR OUR E-PARTNERS USE
ARE NOT YEAR 2000 COMPLIANT.
The risks posed by Year 2000 issues could adversely affect our business in
a number of significant ways. Although we believe that our internally developed
systems and technology are or will be Year 2000 compliant, our information
technology systems nevertheless could be substantially impaired or cease to
operate due to Year 2000 problems. Additionally, we rely on information
technology supplied by third parties, and our participating e-partners also are
heavily dependent on information technology systems and on their own third-party
vendor systems. Year 2000 problems experienced by us or any of these third
parties could materially affect our business. Additionally, the Internet could
face serious disruptions arising from the Year 2000 problem.
We cannot guarantee that any of our e-partners or other Internet vendors
will be Year 2000 compliant in a timely manner, or that there will not be
compatibility problems among information technology systems. We also cannot
guarantee that e-seekers and e-partners will be able to use our online
marketplace without serious disruptions arising from the Year 2000 problem.
Given the pervasive nature of the Year 2000 problem, we cannot guarantee that
disruptions in other industries and market segments will not adversely affect
our business. Moreover, our costs related to Year 2000 compliance, which thus
far have not been material, could ultimately be significant. In the event that
we experience disruptions as a result of the Year 2000 problem, our business
could be materially adversely affected.
CAPACITY CONSTRAINTS AND SYSTEM FAILURES COULD HARM OUR BUSINESS.
If we cannot expand our systems to cope with increased demand, or our
technology systems fail to perform, we could experience:
- unanticipated disruptions in service;
- slower response times;
- decreased e-partner service and satisfaction;
- decreased e-seeker service and satisfaction; or
- delays in the introduction of new products and services.
Any of these factors could impair our reputation, damage the How2.com brand
and materially and adversely affect our business.
We use internally developed and third party systems to operate our online
marketplace, including transaction processing and order management systems
designed to be scalable. We do not know whether
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we will be able to accurately project the rate or timing of any increases to
allow us to upgrade our systems and infrastructure in a timely manner to
accommodate these increases. In addition, e-seekers will depend on Internet
service providers, telecommunications companies and the efficient operation of
their computer networks and other computer equipment for access to our online
marketplace. Each of these has experienced significant outages in the past and
could experience outages, delays and other difficulties due to system failures
unrelated to our systems. Any delays in response time or performance problems
could cause e-seekers to perceive our service as not functioning properly and,
therefore, cause them to use other online services.
Our ability to facilitate transactions successfully and provide high
quality e-seeker service also depends on the efficient and uninterrupted
operation of our computer and communications hardware systems. Our online
marketplace may experience periodic system interruptions from time to time. Our
systems and operations are also vulnerable to damage or interruption from human
error, natural disasters, power loss, telecommunication failures, break-ins,
sabotage, computer viruses, intentional acts of vandalism and similar events.
While we plan to establish redundant servers and a mirror site to provide
limited service during system disruptions, we do not have fully redundant
systems, a formal disaster recovery plan, alternative providers of hosting
services or a mirror site. Any system failure that causes an interruption in
service or decreases the responsiveness of our online marketplace could impair
our reputation, damage our brand name and materially adversely affect our
business.
Our business is highly dependent on our computer and telephone equipment
and software systems. While we maintain backup systems, the temporary or
permanent loss of any of these equipment or systems, through casualty loss due
to events such as fire, flood, earthquake or tornado, or operating malfunction,
could seriously harm our business. While we have property and business
interruption insurance, our insurance may not adequately compensate us for all
losses.
ABANDONED PROPERTY LAWS MAY REQUIRE US TO SURRENDER UNCLAIMED REBATE PAYMENTS TO
A STATE.
The unclaimed property and escheat laws of each state provide that under
circumstances defined in the state's statutes, holders of unclaimed or abandoned
property, possibly including rebate checks that consumers do not cash, also
called "slippage", must surrender that property to the state. As a result, any
state into which we send rebate checks could assert that it is entitled to
unclaimed rebate checks that we have issued to consumers in that state. In 1999,
we recognized slippage of approximately ten percent of the face amount of checks
issued to consumers. If one or more states into which we send a significant
number of rebate checks sought to collect these rebate checks under their
escheat laws, our business could be materially adversely affected.
WE DEPEND ON INCREASING USE OF THE INTERNET AND ON THE GROWTH OF E-COMMERCE. IF
THE USE OF THE INTERNET AND E-COMMERCE DO NOT GROW AS ANTICIPATED, OUR BUSINESS
WILL BE MATERIALLY ADVERSELY AFFECTED.
Our services depend on the increased acceptance and use of the Internet as
a medium of commerce. Rapid growth in the use of the Internet is a recent
phenomenon. As a result, acceptance and use may not develop at projected rates
and a sufficiently broad base of e-seekers may not adopt the Internet as a
medium of commerce. Demand and market acceptance for recently introduced
services and products over the Internet are subject to a high level of
uncertainty, and there exist few proven services and products.
Our business would be materially adversely affected if:
- use of the Internet does not continue to increase or increases, more
slowly than expected; or
- the Internet does not create a viable commercial marketplace, inhibiting
the development of e-commerce and reducing the demand for our products
and services.
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The Internet may not be accepted as a viable long-term commercial
marketplace for a number of reasons, including:
- potentially inadequate development of the necessary communication and
computer network technology, particularly if rapid growth of the Internet
continues;
- delayed development of enabling technologies and performance
improvements;
- delays in the development or adoption of new standards and protocols;
- increased governmental regulation; and
- concerns about security and confidentiality.
INCREASED GOVERNMENT REGULATION COULD LIMIT THE MARKET FOR, OR IMPOSE SALES AND
OTHER TAXES ON THE SALE OF, OUR PRODUCTS AND SERVICES OR ON PRODUCTS AND
SERVICES PURCHASED THROUGH OUR ONLINE MARKETPLACE.
As Internet commerce evolves, we expect that federal, state or foreign
agencies will adopt regulations covering issues such as user privacy, pricing,
content and quality of products and services. It is possible that legislation
could expose companies involved in e-commerce to liability, which could limit
the growth of e-commerce. Legislation could dampen the growth in Internet usage
and decrease its acceptance as a communication and commercial medium. If
enacted, these laws, rules or regulations could limit the market for our
products and services.
We do not collect sales or other similar taxes for goods and services
purchased through our online marketplace. However, one or more states may seek
to impose sales tax collection obligations on out-of-state companies like us
that engage in or facilitate e-commerce. A number of proposals have been made at
the state and local level that would impose additional taxes on the sale of
goods and services over the Internet. These proposals, if adopted, could
substantially impair the growth of e-commerce and could adversely affect our
opportunity to derive financial benefit from such activities. Moreover, a
successful assertion by one or more states or any foreign country that we should
collect sales or other taxes on the exchange of goods and services through our
online marketplace could seriously harm our business.
ONLINE SECURITY BREACHES COULD HARM OUR BUSINESS.
The secure transmission of confidential information over the Internet is
essential in maintaining consumer and supplier confidence in our online
marketplace. Substantial or ongoing security breaches of our system or other
Internet-based systems could significantly harm our business. It is possible
that advances in computer capabilities, new discoveries or other developments
could result in a compromise or breach of the technology used by us to protect
e-seeker transaction data.
We will incur substantial expense to protect against and remedy security
breaches and their consequences. A party that is able to circumvent our security
systems could steal proprietary information or cause interruptions in our
operations. Security breaches also could damage our reputation and expose us to
a risk of loss or litigation and possible liability. Our insurance policies
limits may not be adequate to reimburse us for all losses caused by security
breaches. We cannot guarantee that our security measures will prevent any
potential security breaches.
We also face risks associated with security breaches affecting third
parties conducting business over the Internet. Consumers generally are concerned
with security and privacy on the Internet and any publicized security problems
could inhibit the growth of the Internet and, therefore, our online marketplace
as a means of conducting commercial transactions. In the past, computer viruses,
software programs that disable or impair computers, have been distributed and
have rapidly spread over the Internet. Computer viruses could be introduced into
our systems or those of our e-seekers, e-partners or suppliers, which could
disrupt our online marketplace or make it inaccessible to e-seekers, e-partners
or suppliers.
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WE ARE HEAVILY DEPENDENT ON TELEPHONE, POSTAL AND DELIVERY SERVICES.
We materially rely on services provided by various local and long distance
telephone companies in connection with our rebate and related services. A
significant increase in the cost of telephone services that we cannot recover
through an increase in the pricing of our rebate and related services, or any
significant interruption in telephone services, could have a material adverse
effect on our business.
Our business is also materially dependent on the United States Postal
Service and, to a lesser degree, on private delivery companies. Postal and
delivery service rate increases affect the cost of our mailings and shipments to
consumers. Any increase in postal and other delivery service rates, including
the elimination of existing discounts, could have a material adverse effect on
our business.
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RESULTS OF OPERATIONS
NET REVENUE
During the three months ended August 31, 1999, the Company had net sales of
$901,819, a decrease of $175,499, or 16.3%, over net sales of $1,077,318 for the
three months ended August 31, 1998. For the six months ended August 31, 1999,
the Company had net sales of $1,102,392, a decrease of $1,009,121, or 47.8%,
over net sales of $2,111,513 for the six months ended August 31, 1998. The
Company attributes the decrease in its software product revenues for the year to
the closing of its England distributor, the reduction in purchases from its
Japanese distributor, the deferral of several large OEM/system integrator
purchases and the late introduction of its WinShield Secure PC product. Sales
for the current quarter were down from the comparable period last year due to
the Company focusing it sales efforts during the period on developing its
corporate and government vertical markets versus the educational vertical
market. In addition, while the Company can not quantify the impact, the Company
feels that the Y2K issue has influenced certain customers to allocate IT
resources that would have traditionally been spent on software purchases to the
resolution of this issue.
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COST OF SALES
The costs and expenses incurred in connection with producing the Company's
products for the three months ended August 31, 1999 were $21,856 compared to
$60,912 for the three months ended August 31, 1998, or a decrease of $39,056, or
64.1%. For the six months ended August 31, 1999, cost of sales were $47,777, a
decrease of $83,466, or 63.5%, over cost of sales of $131,243 for the six months
ended August 31, 1998. As a percentage of sales, cost of sales for the three and
six months ended August 31, 1999 were 2.4% and 4.3%, respectively, versus 5.7%
and 6.2% for the three and six months ended August 31, 1998. The decrease in the
Company's cost of sales for the three and six months ended August 31, 1999 over
comparable periods last year can be attributed to the increase in corporate
sales as a percentage of total sales this year over last year.
RESEARCH AND DEVELOPMENT EXPENSE
Research and development costs charged to expense for the three months ended
August 31, 1999, research and development costs were $94,287 versus $146,609 for
the three months ended August 31, 1998, or a decrease of $52,322, or 35.7%. For
the six months ended August 31, 1999, research and development costs were
$244,870 versus $251,333 for the six months ended August 31, 1998, or a decrease
of $6,463, or 3.8%. For the three and six months ended August 31, 1999, the
Company capitalized approximately $165,000 and $293,000, respectively, versus
$247,000 and $745,000 for the comparable periods last year. The decrease in
costs capitalized for the three and six months ended August 31, 1999 related
primarily to a decrease in the level of development work being performed by
outside contract consultants during this period when compared to the same
periods last year. Last year, the Company spent considerable resources in
upgrading their products to be both Windows 98 and NT compliant. This year, the
Company internally developed its WinShield Secure PC product ("Secure PC"), the
total security solution for desktops. The Company completed beta testing on
Secure PC during the quarter and launched this product during August 1999.
Secure PC was originally scheduled for beta testing in April 1999, but was
delayed due to enhancements of the product. Due to the Company's limited
development resources it may be reasonable to expect that the development of new
products and enhancements and upgrades to existing products may be delayed in
the future, which could have an negative impact of the Company's software unit's
operating results.
SELLING AND MARKETING EXPENSE
Selling and marketing expense decreased from $958,904 for the three months ended
August 31, 1998 to $676,449 for the three months ended August 31, 1999, a
decrease of $282,455, or 29.5%. For the year, selling and marketing expenses
increased from $1,430,298 for the six months ended August 31, 1998 to $1,760,445
for the six months ended August 31, 1999. As a percentage of sales, selling and
marketing expenses for the three and six months ended August 31, 1999 were 75.0%
and 159.7%, respectively, versus 89.0% and 67.7% for the three and six months
ended August 31, 1998, respectively.
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During the first quarter, the Company increased both its general marketing
expenditures, which were aimed at increasing the Company's name and product
recognition, as well as its direct marketing expenditures, which were aimed at a
particular market segment, i.e., education, corporate, government, etc. The
majority of these direct marketing expenditures were front-loaded, i.e., the
costs are recognized now, while the benefits are not expected to be derived
until future quarters. During the current quarter, the Company started the
implementation of its sales specific marketing program and general cost control
program and spent considerable less on general marketing. In addition, the
Company allocated considerable resources, in the past, to building its inside
and outside sales infrastructure. The Company does not anticipate that it will
be required to allocate the same amount of resources in the future. As a result,
the Company would anticipate that, in future quarters, these expenses would
continue to be reduced on a dollar basis.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses for the three months ended August 31, 1999
were $214,458 versus $426,152 for the three months ended August 31, 1998, or a
decrease of $211,694, or 49.7%. General and administrative
expenses decreased $311,806, or 39.9%, from $781,491 for the six months ended
August 31, 1998 to $469,685 for the six months ended August 31, 1999. The
decrease can be attributed to the cost control programs implemented by the
Company during the period. The Company is continuing to explore ways to reduce
its general and administrative expenses.
DEPRECIATION AND AMORTIZATION EXPENSE
Depreciation and amortization expense for the three months ended August 31, 1999
was $336,316, compared to $371,491 for the three months ended August 31, 1998.
For the six months ended August 31, 1999, depreciation and amortization expense
was $658,709, compared to $723,917 for the six months ended August 31, 1998, or
a decrease of $65,208, or 9.0%. During the last quarter of the previous fiscal
year, the Company wrote-off approximately $1,200,000 of purchased software costs
which had the impact of reducing the depreciation and amortization expense for
the three and six months ended August 31, 1999 by approximately $125,000 and
$250,000, respectively. This was offset by the commencement of amortization on
certain capitalized product development costs relating to products that became
available for sale during the periods.
OTHER INCOME (EXPENSE)
Interest expense for the three months and six months ended August 31, 1999 was
$3,642 and $15,120, respectively, compared to $30,847 and $82,051 for the three
and six months ended August 31, 1998, respectively. This resulted primarily from
the Company having less interest bearing debt during this period than it did
during the same period last year. Equity in loss of unconsolidated affiliate
was $2,242,169 for the three months ended August 31, 1999 and $2,598,045 for the
six months ended August 31, 1999. The large increase in the loss during the
current quarter related to the Company's Internet subsidiary allocating a
considerable amount of resources to developing its corporate infrastructure. The
Company would expect that these losses would continue to be significant for at
least the foreseeable future as its Internet subsidiary continues to develop its
infrastructure and launches its marketing programs.
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OPERATING LOSS BEFORE EXTRAORDINARY ITEM
As a result of the foregoing, for the three months ended August 31, 1999, the
Company reported a net loss before extraordinary items of $2,677,593, compared
to a net loss of $910,031 for the same period last year. For the six months
ended August 31, 1999, the Company reported a net loss before extraordinary
items of $4,696,204 compared to $1,281,254 for the same period last year.
EXTRAORDINARY ITEM - FORGIVENESS OF DEBT
During the three and six months ended August 31, 1999, the Company recognized a
gain on the settlement of debts of $205,847 and $733,068, respectively. These
gains related 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 was 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
period.
NET LOSS
As a result of the aforementioned, the Company, for the three and six months
ended August 31, 1999, reported a net loss of $2,677,593 and $4,696,204
respectively, compared to a net loss of $704,184 and $548,186 for the three and
six months ended August 31, 1998.
DIVIDENDS ON PREFERRED STOCK
Preferred stock dividends consisted primarily of dividends accrued on Series D
preferred stock. In June 1999, the Company converted the $2,000,000 of Series D
preferred stock, plus dividends in arrears of approximately $238,000, into
2,081,937 shares of the Company's common stock.
YEAR 2000 COMPLIANCE
The Company has conducted a review of its computer systems and products to
identify those that could be affected by the "Year 2000 Problem," the result of
computer programs using two digits rather than four to define the year portion
of dates. The Company determined that none of its significant systems or
products fail to distinguish the year 2000 from the year 1900. The review
continues, in an ongoing process, to examine the risk, if any, to the Company,
of vendor or customer exposure to the Year 2000 Problem. To date, no exposure
has been discovered which would have a material adverse effect on the Company.
Certain software incorporated in the Company's products has been certified by
the vendors to be compliant. The financial impact of Year 2000 compliance has
not been, and is not expected to be, material to the Company's financial
position or results of operations in any given year.
36
<PAGE> 37
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash and cash equivalents at August 31, 1999 were $81,045.
Cash flows from operations were a negative $2,438,490 for the six months ended
August 31, 1999, compared to negative $2,934,447 for the six months ended
August 31, 1998. This decrease was primarily due to an increase in the Company's
accounts receivable turnover offset by an increase in the Company's accounts
payable turnover and an increase in the net loss for the period.
Cash used in investing activities were approximately $375,250 for the six
months ended August 31, 1999, compared to approximately $796,919 for the same
period last year. This decreased resulted from the Company spending less on
software development activities this period.
Cash flows provided by financing activities were $684,408 for the six months
ended August 31, 1999, compared to $5,653,687 for the six months ended
August 31, 1998. This decrease was due primarily to less capital being raised
by the Company during this period.
As a result of the aforementioned factors, cash and cash equivalents decreased
by $2,129,332 for the six months ended August 31, 1999, versus an increase of
approximately $1,922,321 for the same period last year.
The Company will need to seek additional capital to fund its operations for at
least the remainder of the fiscal year. While the Company has been successful in
the past in raising additional capital when needed, there can be no assurances
that they will be successful in the future, or if successful it will be
available on acceptable terms or will not have a dilutive effect on existing
shareholders.
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
On January 7, 1999, the Company's former Houston landlord filed a lawsuit
against the Company alleging a breach of a lease covering the Company's former
Houston office space. The suit sought damages in excess of $750,000, plus
attorney's fees, pre and post interest and court costs. In July 1999, the
parties reached an agreement in principle to settle the suit for $325,000 to be
paid over nine months, with an agreed judgment in the amount of $460,000 in the
event the Company fails to make its payments under the settlement agreement.
The Company and its President are involved in an arbitration proceeding with
Vestcom Ltd., a group that claims it is entitled to compensation and a finder's
fee for introducing the Company to a third party. Vestcom Ltd. is seeking
damages of the value of 100,000 shares of the Company's common stock (alleged to
be $1,900,000), plus 50% of additional compensation paid by the Company to such
third party. The Company believes it has defenses to such claims. The Company
and its President filed a declaratory judgment action against Vestcom seeking to
37
<PAGE> 38
determine that the alleged contract was not valid based on the Company's
defenses. 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 October 1998, the Texas state court entered a judgment and preliminary
injunction in favor of the Company and its president that the purported
agreement was a forgery. As a result, the arbitration proceeding was dismissed
by the American Arbitration Association. The defendant has appealed the decision
of the Texas court. In November 1998, Vestcom filed a lawsuit against the
Company in Texas state court styled Vestcom v. Citadel in the 68th Judicial
Court, Dallas County, Texas, reasserting the same basic claims as in the
arbitration proceeding. The parties held mediation in September 1999 and were
not able to come to agreement with regards to a settlement, but agreed to
continue settlement discussion.
In August 1998, Janssen Meyers Associates L.P. ("JM") filed a lawsuit against
the Company. The suit alleges that the Company owes the plaintiffs a fee in the
amount of $16,500,000 plus interest and attorney's fees in connection with
services allegedly performed by JM in respect of the merger between LoneStar and
Old Citadel and related matters. The Company believes such claims are without
merit and intends to vigorously defend against the claims. The lawsuit, styled
Janssen Meyers Associates, L.P. v. Citadel Technology, Inc., was filed in the
Supreme Court of the State of New York, County of New York. The Company has
removed the case to federal court in the Southern District of New York.
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. Unfavorable
resolutions of these lawsuits or costs of litigation and settlement could have a
material adverse effect on our results of operations or financial condition.
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
SALES OF UNREGISTERED SECURITIES DURING THE QUARTER
In the quarter the Company's subsidiary, How2, issued 3,382,800 post-split
shares of its common stock pursuant to private placements to accredited
investors under Section 4(2) of the Securities Act, for commitments for
proceeds of $12,879,000.
38
<PAGE> 39
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Exhibit 27 Financial Data Schedule
(b) REPORTS ON FORM 8-K.
On June 3, 1999, the Company filed a Current Report on Form 8-K relating to its
acquisition of the Forward Companies by How2.
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: October 20, 1999 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>
39
<PAGE> 40
Index to Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
---------- -------------
<S> <C>
27 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED FINANCIAL STATEMENTS OF CITADEL TECHNOLOGY, INC. FOR THE SIX MONTHS
ENDED AUGUST 31, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
CONSOLIDATED FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> FEB-28-1999
<PERIOD-START> MAR-01-1999
<PERIOD-END> AUG-31-1999
<CASH> 81,045
<SECURITIES> 0
<RECEIVABLES> 1,839,839
<ALLOWANCES> 1,058,245
<INVENTORY> 149,862
<CURRENT-ASSETS> 1,474,356
<PP&E> 967,341
<DEPRECIATION> 623,751
<TOTAL-ASSETS> 17,811,725
<CURRENT-LIABILITIES> 1,743,944
<BONDS> 0
1
0
<COMMON> 473,369
<OTHER-SE> 15,594,411
<TOTAL-LIABILITY-AND-EQUITY> 17,811,725
<SALES> 1,102,392
<TOTAL-REVENUES> 1,102,392
<CGS> 47,777
<TOTAL-COSTS> 47,777
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 15,120
<INCOME-PRETAX> (4,696,204)
<INCOME-TAX> 0
<INCOME-CONTINUING> (4,696,204)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (4,696,204)
<EPS-BASIC> (.11)
<EPS-DILUTED> (.11)
</TABLE>
