<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 MAY 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[ ] No [X]
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 September 21, 1999
- -------------------------------------- ---------------------------------
<S> <C>
Common Stock, Par value $.01 per share 43,361,348
</TABLE>
Transitional Small Business Disclosure Format Yes [ ] No [X]
<PAGE> 2
CITADEL TECHNOLOGY, INC.
FORM 10-QSB
QUARTERLY PERIOD ENDED MAY 31, 1999
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
<TABLE>
<CAPTION>
Page
----
<S> <C>
Item 1. Financial Statements
Consolidated Balance Sheets
as of May 31, 1999 and February 28, 1999 ....................... 3
Consolidated Statements of Operations
for the three months ended May 31, 1999 and 1998 ............... 5
Consolidated Statements of Cash Flow
for the three months ended May 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 ............................ 15
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ................................................. 45
Item 6. Exhibits and Reports on Form 8-K .................................. 46
Signatures ................................................................ 47
</TABLE>
<PAGE> 3
PART 1 - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CITADEL TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
MAY 31, FEBRUARY 28,
ASSETS 1999 1999
----------- -----------
(UNAUDITED)
<S> <C> <C>
CURRENT ASSETS
Cash and cash equivalents $ 7,635,010 $ 3,386,369
Accounts receivable, less allowance for returns and
doubtful accounts of $1,275,000 and $1,208,000 4,631,491 466,288
Notes receivable from related parties 333,934 478,933
Receivables from sale of common stock of subsidiary 2,920,250 6,042,000
Inventory 146,764 148,676
Other 404,481 208,223
----------- -----------
Total current assets 16,071,930 10,730,489
PROPERTY AND EQUIPMENT, net of accumulated 1,118,700 386,901
depreciation of $1,060,169 and $510,051
PURCHASED SOFTWARE, net of accumulated
amortization of $2,840,972 and $2,718,486 1,272,220 1,394,706
CAPITALIZED SOFTWARE DEVELOPMENT COSTS,
net of accumulated amortization of $714,849 and $577,000 1,173,063 1,181,052
GOODWILL, net of accumulated amortization of $112,919 13,424,282 --
OTHER ASSETS 699,961 448,372
----------- -----------
$33,760,156 $14,141,520
=========== ===========
</TABLE>
The accompanying notes are an integral part of these statements.
3
<PAGE> 4
CITADEL TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS - CONTINUED
<TABLE>
<CAPTION>
MAY 31, FEBRUARY 28,
LIABILITIES AND STOCKHOLDERS' EQUITY 1999 1999
------------ ------------
(UNAUDITED)
<S> <C> <C>
CURRENT LIABILITIES
Current maturities of long-term debt $ 267,614 $ 311,812
Notes payable 333,057 347,424
Promotional payable 8,158,339
Accounts payable and accrued expenses 1,994,405 2,247,600
------------ ------------
Total current liabilities 10,753,415 2,906,836
LONG-TERM LIABILITIES
Capital lease obligations 20,943 --
Debt, less current liabilities 183,558 --
------------ ------------
204,501 --
------------ ------------
Total liabilities 10,957,916 2,906,836
MINORITY INTEREST IN CONSOLIDATED SUBSIDIARY 9,478,625 2,742,432
COMMITMENTS AND CONTINGENCIES -- --
STOCKHOLDERS' EQUITY
Common stock, $.01 par value per share; authorized
60,000,000 shares; issued, 45,142,065 shares
at 5/31/99 and 43,259,274 shares at 2/28/99 451,420 432,592
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) 20 20
Equity Notes 100,000 150,000
Additional paid-in capital 39,580,299 32,985,018
Accumulated deficit (22,550,433) (20,641,875)
Notes receivable for exercise of options/warrants (1,757,453) (1,933,265)
Treasury stock, at cost (4,164,613 shares) (2,500,239) (2,500,239)
------------ ------------
Total stockholders' equity 13,323,615 8,492,252
------------ ------------
$ 33,760,156 $ 14,141,520
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
4
<PAGE> 5
CITADEL TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MAY 31,
1999 1998
------------ ------------
(UNAUDITED) (UNAUDITED)
<S> <C> <C>
Net sales $ 1,592,485 $ 1,034,195
Cost of sales 937,918 70,331
------------ ------------
Gross profit 654,567 963,864
Operating expenses
Research and development expenses 303,076 104,724
Selling and marketing expenses 1,282,835 471,394
General and administrative expenses 706,631 355,339
Depreciation and amortization expense 519,703 352,426
------------ ------------
2,812,245 1,283,883
------------ ------------
Operating loss (2,157,678) (320,019)
Other income (expense)
Interest, net (11,478) (51,204)
Settlement of lawsuits (25,000) --
Other 28,276 --
------------ ------------
(8,202) (51,204)
------------ ------------
Net loss before minority interest (2,165,880) (371,223)
Minority interest in loss of consolidated
subsidiary 283,011 --
------------ ------------
Net loss before extraordinary item (1,882,869) (371,223)
Extraordinary item - forgiveness of debt -- 527,221
------------ ------------
Net loss (1,882,869) 155,998
Preferred stock dividend requirement (55,452) (20,000)
------------ ------------
Net loss allocable to common stockholders $ (1,938,321) $ 135,998
============ ============
Loss per share - basic and diluted
Loss before extraordinary item $ (0.05) $ (0.02)
Extraordinary item -- 0.02
------------ ------------
Net loss per share $ (0.05) $ 0.01
============ ============
Weighted average shares outstanding 40,490,633 21,989,756
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
5
<PAGE> 6
CITADEL TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MAY 31,
1999 1998
------------ ------------
(UNAUDITED) (UNAUDITED)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $ (1,882,869) $ 155,998
Adjustments to reconcile net loss to net cash
used by operating activities
Depreciation and amortization 519,703 352,426
Gain on settlement of debt (527,221)
Minority interest in loss of consolidated
subsidiary (283,011) --
Changes in operating assets and liabilities
Accounts receivable (594,197) (704,760)
Notes receivable from related parties 144,460 (1,613)
Other current assets 73,729 (265,445)
Inventory 1,722 (55,796)
Bank overdraft -- (10,249)
Accounts payable and accrued expenses (891,258) 116,576
Promotional payable 254,949 --
Other assets (235,622) 167,263
------------ ------------
NET CASH USED BY OPERATING ACTIVITIES (2,892,394) (772,821)
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures (151,306) (9,369)
Development of software (129,867) (498,503)
Acquisition of companies, net (5,057,280) --
------------ ------------
NET CASH USED BY INVESTING ACTIVITIES (5,338,453) (507,872)
CASH FLOW FROM FINANCING ACTIVITIES
Net change in debt (94,342) (76,081)
Proceeds from the sale of preferred stock -- 2,595,788
Proceeds from the sale of subsidiary stock 11,642,502 --
Proceeds from sale of common stock 931,328 --
------------ ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 12,479,488 2,519,707
------------ ------------
Net increase (decrease) in cash
and cash equivalents 4,248,641 1,239,014
Cash and cash equivalents at the beginning
of the period 3,386,369 8,555
------------ ------------
Cash and cash equivalents at the end
of the period $ 7,635,010 $ 1,247,569
============ ============
</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 May 31,
1999 and for the three month period ended May 31, 1999 and May 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 months ended May 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 - Our results of operations for future periods will not
include results from our Internet subsidiary regarding reduction of Citadel's
ownership of How2HQ). All significant intercompany accounts and transactions
have been eliminated.
During the quarter, the Company's subsidiary, How2HQ.com, Inc. ("How2HQ"),
acquired the assets of 2-Lane Media, Inc. ("2-Lane"), a web site and e-commerce
design company, and The Forward Companies ("Forward"), a rebate and promotional
fulfillment services company that offers its high-tech and blue chip clients
end-to-end solutions for designing, implementing and fulfilling merchandise and
consumer rebate programs. Each of these acquisitions was accounted for as a
purchase and, accordingly, their operating results have been included in the
Company's consolidated financial statements since the date of acquisition. In
addition, subsequent to the end of the fiscal quarter, in August 1999, How2HQ
completed the acquisition of certain of the assets of Broadcast Production
Group, Inc. ("BPG"). Under the terms of the acquisition agreements, How2HQ
acquired the multimedia and content conversion assets from BPG, as well as
retaining the services of certain key employees.
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 1. BASIS OF PRESENTATION, CONTINUED
Reclassifications
Certain amounts for the period ended May 31, 1998 have been reclassified to
conform to the presentation for the period ended May 31, 1999.
NOTE 2. CAPITAL TRANSACTIONS
In prior fiscal years, Citadel had issued equity notes which were unsecured and
convertible into common stock at between 70% and 80% of the average market price
of the common stock and were payable at maturity in common stock. Interest at 8%
is payable in common stock. During the quarter, Citadel converted $50,000 of
equity notes plus accrued interest for approximately 458,000 shares of Citadel
common stock. The number of shares issued was based on the conversion price in
effect as of the date the notes had matured, July 31, 1997.
During the quarter the Citadel issued 1,424,660 shares of its common stock in
connection with the exercise of certain options and warrants for net proceeds of
$776,268.
How2HQ issued 1,178,251 shares (4,713,004 post-split) of common stock in private
placements, during the quarter, for $8,650,500. In addition, How2HQ issued
options to purchase 1,185,000 shares (4,740,000 post-split) of its common stock,
during the quarter, to employees, directors and others at post-split exercise
prices ranging from $.25 to $1.50.
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 How2HQ upon compliance with Securities and
Exchange Commission ("SEC") requirements applicable to Citadel and How2HQ in
connection with the proposed spin-off. 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
How2HQ to Citadel stockholders on a timely basis or at all.
8
<PAGE> 9
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
NOTE 2. CAPITAL TRANSACTIONS, CONTINUED
In addition, Citadel has agreed to convert certain shares of How2HQ common stock
issued in connection with certain subscription agreements into shares of Citadel
common stock, in the event How2HQ 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 How2HQ
common stock issued in connection with the acquisition of 2-Lane Media by How2HQ
into up to 500,000 Citadel shares at the option of the 2-Lane Media shareholders
in the event How2HQ 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
9
<PAGE> 10
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 to talk
with that purpose in mind.
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. ACQUISITIONS
During the quarter ended May 31, 1999, the Company's subsidiary, How2HQ,
acquired two companies to enhance its strategy in becoming a leading lifestyle
improvement web site.
On March 17, 1999, How2HQ acquired 2-Lane Media, Inc. ("2-Lane"), a web site and
e-commerce design company, for 1,200,000 shares (post-split) of How2HQ common
stock with a guaranteed value of $1.25 per share; in the event the common stock
of How2HQ is not publicly traded by February 1, 2000, the sellers have the
option to convert the How2HQ shares into a maximum of 500,000 shares of common
stock of Citadel having an agreed value of $1,500,000. Also options were granted
to purchase 200,000 shares (post-split) of How2HQ common stock for $.25 per
share. The transaction was accounted for as a purchase. Under the transaction,
How2HQ recorded approximately $1,870,000 in goodwill. The goodwill is being
amortized on a straight-line over 5 years.
10
<PAGE> 11
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
NOTE 4. ACQUISITIONS, CONTINUED
On May 20, 1999, How2HQ acquired The Forward Companies, a rebate and promotional
fulfillment services company, for $8,000,000 in cash and 1,000,000 shares plus
and 1,200,000 contingent shares (post-split) of How2HQ common stock with a
guaranteed value of $2.50 per share. The issuance of the 1,200,000 shares is
contingent upon the attainment of certain EBITDA numbers and as such the value
of these shares ($3,000,000) was not included in the purchased costs associated
with the transaction in accordance with APB No.16 and EITF 95-8. In addition,
options were granted to the shareholders of Forward to purchase 800,000 shares
(post-split) of How2HQ common stock at $2.50 per share if certain earn-out
provisions are met. The transaction was accounted for as a purchase. Under the
transaction, How2HQ recorded approximately $11,660,000 in goodwill. The goodwill
is being amortized on a straight-line method over 10 years. In the event the
aforementioned 1,200,000 shares are earned, then the recorded goodwill will be
increased by $3,000,000.
As the acquisitions have been accounted for under the purchase method of
accounting, their operating results have been included in the Company's
consolidated financial statements since the date of each respective company's
acquisition.
The following unaudited pro forma results of operations for the three months
ended May 31, 1999 and 1997 are as if the acquisitions of 2-Lane and Forward had
occurred at the beginning of each period presented. The pro forma information
has been prepared for comparative purposes only and is not indicative of what
operating results would have been if the acquisitions had taken place at the
beginning of each period presented or of future operating results.
<TABLE>
<CAPTION>
Three months ended
May 31, 1999 May 31, 1998
------------ ------------
<S> <C> <C>
Net revenue $ 9,883,926 $ 3,421,067
============ ===========
Net income (loss) ($ 3,523,477) ($ 305,934)
============ ===========
Basic/diluted net loss per share ($.09) ($.01)
============ ===========
</TABLE>
11
<PAGE> 12
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
NOTE 5. SUBSEQUENT EVENTS
Equity Notes
In July 1999, the Company converted the remaining $100,000 balance of equity
notes for approximately 76,000 shares of Citadel common stock.
Preferred Stock
In June 1999, the Company converted the $2,000,000 of Series D preferred stock
held by Metamor Worldwide, plus accrued dividends of approximately $238,000,
into 2,081,937 shares of Citadel common stock.
Subsidiary Transactions
Subsequent to May 31, 1999, How2HQ issued 585,000 (post split) shares of common
stock in private placements for $2,850,000. As of September 22, 1999, Citadel's
ownership interest in How2HQ has been reduced to less than 50%. In addition,
How2HQ issued options to purchase 3,721,250 shares (post split) of common stock
at prices ranging from $2.50 to $5.00 and vest in varying amounts through 2002.
On August 13, 1999, How2HQ announced a 4 for 1 stock split effective July 7,
1999. How2HQ shareholders of record as of July 7, 1999 will be issued a
certificate representing 3 additional shares of How2HQ common stock for each
share of How2HQ common stock held as of the record date.
On August 9, 1999, How2HQ completed the acquisition of certain assets of
Broadcast Production Group, Inc. ("BPG"). Under the terms of the acquisition
agreements, How2HQ acquired substantially all of the multimedia production and
content conversion assets from BPG, as well as retaining the services of certain
key employees. How2HQ paid $500,000 in cash and 200,000 (post-split) shares of
How2HQ common stock with a guaranteed post-split value of $10.00 per share
following an initial public offering, if any
12
<PAGE> 13
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
NOTE 6. SEGMENTS
Citadel and its subsidiaries principally engage in the following reportable
segments: (1) the development and sale of computer software products, and (2)
Internet and e-commerce solutions, including the How2HQ.com web site, web site
design, content conversion and multimedia production and promotional and rebate
fulfillment services. Prior to February 28, 1999, the Company had only one
reportable segment, software.
The Company identifies segments based on management responsibility within the
corporate structure. The Company's software segment includes security and
administration products for both computer networks and desktop personal
computers. The Internet and e-commerce solutions segment includes the operations
of its How2HQ.com web site, web site and e-commerce design services, and
promotional and rebate fulfillment. The Company measures segment profit (loss)
as operating profit (loss), which is defined as income (loss) before minority
interest and income taxes. Segment information and a reconciliation to income
(loss), before minority interest and income taxes is as follows:
<TABLE>
<CAPTION>
Three months ended May 31, 1999 Software Internet Consolidated
- ------------------------------- ------------ ------------ ------------
<S> <C> <C> <C>
Revenue from external customers $ 200,573 $ 1,391,912 $ 1,597,485
Operating income (loss) $ (1,662,735) $ (503,145) $ (2,165,880)
Total assets $ 5,497,282 $ 28,262,874 $ 33,760,156
</TABLE>
13
<PAGE> 14
CITADEL TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
NOTE 8. LOSS PER SHARE
<TABLE>
<CAPTION>
Loss before
Extraordinary Extraordinary
Credit Credit Net loss
------------- ------------- ------------
<S> <C> <C> <C>
Three months ended May 31, 1999
- -------------------------------
Loss $ (1,882,869) $ -- $ (1,882,869)
Preferred dividend requirement (55,452) -- (55,452)
------------ ------------ ------------
$ (1,938,321) $ -- $ (1,938,321)
============ ============ ============
Weighted average common shares outstanding 40,490,633 40,490,633
Loss per share - basic and diluted $ (.05) $ (.05)
============ ============
Three months ended May 31, 1998
- -------------------------------
Earnings (loss) $ (371,223) $ 527,221 $ 155,998
Preferred dividend requirement (20,000) -- (20,000)
------------ ------------ ------------
$ (391,223) $ 527,221 $ 135,998
============ ============ ============
Weighted average common shares outstanding 21,989,756 21,989,156
Earnings (loss) per share - basic and diluted $ (.02) $ .02 $ .01
============ ============ ============
</TABLE>
14
<PAGE> 15
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 develops and markets security and administration software products
for both computer networks and desktop personal computers, and through its
Internet subsidiary, How2HQ.com ("How2HQ"), provides Internet and e-commerce
solutions, including its How2HQ.com web site, web site design services, content
conversion and multimedia production services and promotional and rebate
fulfillment services. 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 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.
COMPANY AWARDS AND PRODUCT RECOGNITION
Winning on Windows -- In April 1999, Citadel announced that it was selected by
Microsoft Corp. and CMP Media (Nasdaq: CMPX) as one of the fastest growing
independent software vendors (ISVs) for Windows. Citadel was ranked as the 15th
fastest growing ISV in the first ever "Winning on Windows." The "Winning on
Windows" ranking was announced in April at an awards reception in Chicago at the
Spring Comdex/Windows World Show. The announcement of the ISV 75 marks the first
annual "Winning on Windows" awards campaign, which is designed to identify and
promote the fastest-growing Windows software companies and recognize industry
growth and innovation. Top companies were selected and ranked according to the
highest percentage revenue growth between 1997 and 1998. The research and
selection process was conducted by Austin, Texas-based researcher, Reality
Research (a wholly owned subsidiary of CMP Media).
15
<PAGE> 16
In addition, 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.
HOW2HQ.COM - PLANNED SPINOFF, ACQUISITIONS AND RELATED MATTERS
In January 1999, Citadel announced that it had formed a subsidiary, How2HQ.com,
Inc. (formerly inLighten.com and shoppingwave.com), to implement Citadel's
Internet and e-commerce strategies. The How2HQ.com web site initially offers
channels including How2 Headquarters (How2HQ), How2Work, How2Play, How2Home and
How2Shop&Save. How2HQ also provides a complete range of Internet and e-commerce
solutions, from award-winning web site design and content conversion and
multimedia production services, to back end integration and order and rebate
fulfillment. 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 How2HQ 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 How2HQ in connection
with the proposed spinoff. 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.
In March 1999 How2HQ completed the acquisition of 2-Lane Media, Inc.
(www.2lm.com), the recipient of more than 65 major interactive industry awards
for interactive/multimedia communications. 2-Lane Media offers web site and
e-commerce design services for a diverse client roster that spans the worldwide
Fortune 1000. 2-Lane Media's mission has been to utilize the vast potential of
multimedia technologies and the Internet to help companies effectively
communicate information. The 2-Lane Media team was one of the first to open a
new multimedia marketing medium to the film industry by creating Interactive
Press Kits for upcoming feature films. 2-Lane Media also pioneered the use of
Macromedia's new interactive Shockwave plug-in, featuring the technology in
sites for several major motion pictures. 2-Lane's client list reads like a
"Who's Who" of industry leaders including Nestle, Disney, Transamerica, Golden
Books, Rockwell International Corp. and Tenet Healthcare. 2-Lane Media has also
recently signed several new e-commerce accounts including Prolong, a leading
manufacturer of car-care products best known for its effective infomercials, and
Pacific Sunwear, the largest national retailer of active and beachwear for teens
and twentysomethings. Both projects revolve around creating lifestyle-
appropriate communities that integrate with an on-line shopping environment. The
purchase price for 2-Lane Media consisted of 300,000 shares (1,200,000
post-split) of How2HQ common stock and options to purchase an additional 50,000
shares (200,000 post-split). The 300,000 shares are convertible at the option of
the holders into a maximum of 500,000 shares of Citadel common stock in the
event the How2HQ shares do not become publicly traded by March 2000.
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In May 1999, How2HQ completed the acquisition of The Forward Companies
("Forward"), a leading product rebate and promotional fulfillment operation that
offers its high-tech and blue chip clients end-to-end solutions for designing,
implementing and fulfilling merchandise and consumer rebate programs. In
addition to processing rebates for modems, printers, scanners and dozens of
popular software programs, Forward handles fulfillment assignments for
e-commerce, high technology and other companies. Forward leases a 67,000 square
feet state-of-the-art facility in Coppell, Texas (near the Dallas/Fort Worth
International Airport). Forward's client list includes numerous high tech
companies, including Microsoft, 3Com, Hewlett-Packard, Canon, UMax, Cross
Computing, and Diamond Multimedia, as well as other leading companies such as
Quaker State, Alcon Surgical, and Southwestern Bell. The terms of the
transaction included a cash payment of $8 million and 550,000 shares (2,200,000
post-split) of How2HQ common stock with a guaranteed floor of $10 per share
($2.50 post-split) for a period ending upon effectiveness of an initial public
offering. Of these shares 300,000 (1,200,000 post split) have been escrowed and
are contingent upon the obtainment of certain EBITDA levels. How2HQ also granted
to the shareholders of the Forward Companies warrants to purchase an additional
200,000 shares at $10 per share (800,000 shares and $2.50 post-split), in the
event certain earn-out provisions are met.
In July 1999, the Board of Directors of How2HQ 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 How2HQ
shareholders of record on July 7, 1999. How2HQ 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, How2HQ 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, How2HQ retained certain members of the BPG management team
as employees of How2HQ. The purchase price consisted of $500,000 in cash and
200,000 post-split shares of How2HQ.com common stock. In connection with the
acquisition, How2HQ 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 How2HQ, based on the average closing
price over the 30 day period.
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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 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 has 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.
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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.
OUR RESULTS OF OPERATIONS FOR FUTURE PERIODS WILL NOT INCLUDE RESULTS FROM OUR
INTERNET SUBSIDIARY. Results for Citadel's future periods will not include
results from the How2HQ.com Internet subsidiary because the ownership level of
Citadel has decreased below 50% as a result of acquisitions and private
placements , although Citadel will continue to own 17,000,000 shares (after the
four-for-one stock split effective in July 1999 and the proposed stock dividend
to Citadel shareholders). The Internet subsidiary accounted for a substantial
majority of our revenues for the most recent periods and it is anticipated that
How2HQ will continue to represent the substantial majority of revenues for
future periods.
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WE MAY NOT BE ABLE TO EFFECT THE DISTRIBUTION OF HOW2HQ SHARES. In January 1999,
Citadel announced the formation of How2HQ, to implement Citadel's Internet and
e-commerce strategies. Citadel also previously announced that it intends to
distribute 750,000 shares (3,000,000 post split) of How2HQ common stock to
Citadel's shareholders upon compliance with the Securities and Exchange
Commission (SEC) requirements applicable to Citadel and How2HQ in connection
with the proposed spinoff. 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 How2HQ to Citadel shareholders on a timely basis or at all.
In addition, Citadel has agreed to convert the shares of How2HQ common
stock issued in connection with the acquisition of 2-Lane Media by How2HQ into
up to 500,000 Citadel shares at the option of the 2-Lane Media shareholders in
the event How2HQ does not become publicly traded by March 2000. Pursuant to the
terms of the subscription agreements between How2HQ 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 How2HQ 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
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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.
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.
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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 How2HQ
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 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.
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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.
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.
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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.
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 the expansion of 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, HOW2HQ.COM.
The following are certain risks related to the business of How2HQ.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.
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HOW2HQ'S BUSINESS AND FUTURE PROSPECTS ARE EXTREMELY DIFFICULT TO EVALUATE
BECAUSE ITS OPERATING HISTORY IS LIMITED. How2HQ was formed in January 1999 and
its web site began initial operations in September 1999. How2HQ acquired its
rebates operation in May 1999. As a result, How2HQ has only a limited operating
history on which you can base an evaluation of its business and prospects. Its
prospects must be considered in light of the risks, uncertainties, expenses and
difficulties frequently encountered by companies in their early stages of
development. These risks are heightened in new and rapidly evolving markets,
such as online commerce, using new and unproven business models. To address
these risks and uncertainties, How2HQ must, among other things: continue to
develop and upgrade its technology infrastructure to support the initial
operations and growth of its network; attract leading tutorial content providers
and consumers to the How2HQ.com service; develop and capitalize on new our new
business to business to consumer business model; develop and enhance its brand,
and expand its product and service offerings; attract, integrate, retain and
motivate qualified personnel; adapt to meet changes in its markets and
competitive developments; and generate revenues from multiple new sources,
including sources from which we have not generated revenues to date. How2HQ may
not successfully accomplish any of these objectives. If How2HQ does not
successfully address these risks, its business would be seriously harmed.
THE HOW2HQ.COM WEB SITE WAS ONLY RECENTLY INTRODUCED AND IS AT AN EARLY STAGE OF
DEVELOPMENT AND MARKET ACCEPTANCE. How2HQ began operating its How2HQ.com web
site in September 1999, and only a limited number of e-seekers are using its web
site. Broad and timely acceptance of its How2HQ.com web site, which is critical
to its future success, is subject to a number of significant factors. These
factors include: the ability of its network to support large numbers of
e-seekers is unproven; it needs to acquire or develop relevant content; it must
effectively market and establish the brand of its site; it needs to
significantly enhance the features and services of its How2HQ.com web site to
achieve widespread commercial acceptance of that site; and it needs to
significantly expand its internal resources to support planned growth of its
How2HQ.com web site. How2HQ expects to derive a significant portion of its
long-term future revenue from its How2HQ.com web site. Although How2HQ has
developed pricing and revenue models for its How2HQ.com web site, these models
have not yet proven to be profitable. If How2HQ is unable to establish pricing
and revenue models acceptable to its e-seekers and e-partners, its How2HQ.com
web site may not be commercially successful. This would seriously harm its
business, particularly if How2HQ experience a decline in the growth rate of
revenues from its rebate and fulfillment programs.
HOW2HQ HAS A HISTORY OF NET LOSSES AND EXPECT TO CONTINUE TO INCUR NET LOSSES IN
THE FUTURE. How2HQ has an accumulated deficit. How2HQ has not achieved
profitability and expects to incur losses for the foreseeable future. How2HQ
expects to derive a significant portion of its revenues for the next 24 months
from its recently commenced online rebate program. Its online rebate program
carries a low gross margin. How2HQ will need significant revenue growth to cover
expenses if other, higher margin, products and services offered on its web site
are not successful. Although its revenues have grown recently, How2HQ may not be
able to sustain that growth. In fact, How2HQ may not have any revenue growth,
and its revenues could decline. Over the longer term, How2HQ expects to derive
revenues from its web site, which is based on
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an unproven business model. Moreover, How2HQ expects to incur significantly
higher levels of sales and marketing, and general and administrative expenses.
As a consequence of these factors, How2HQ may never be profitable.
HOW2HQ MAY NEED TO RAISE ADDITIONAL CAPITAL IN ORDER TO REMAIN COMPETITIVE IN
THE ELECTRONIC COMMERCE INDUSTRY. THIS CAPITAL MAY NOT BE AVAILABLE ON
ACCEPTABLE TERMS, IF AT ALL. How2HQ may need to raise additional funds and
How2HQ cannot be certain that it will be able to obtain additional financing on
favorable terms, if at all. If How2HQ cannot raise funds on acceptable terms, if
and when needed, it may not be able to develop or enhance its services, take
advantage of future opportunities, or grow its business or respond to
competitive pressures or unanticipated requirements, which could seriously harm
its business.
ITS QUARTERLY OPERATING RESULTS WILL LIKELY VARY SIGNIFICANTLY IN THE FUTURE.
How2HQ expects that its revenues and operating results may vary significantly
from quarter to quarter. As a result, quarter-to-quarter comparisons of its
results of operations may not be meaningful. In some future quarter or quarters,
its operating results are likely to fall below expectations.
Its quarterly operating results may vary depending on a number of factors,
including: demand for its rebate and fulfillment services and its Internet
services; fluctuations in average face amount of rebates; actions taken by its
competitors, including new product introductions and enhancements; delays or
reductions in spending for, or implementation of, technology by potential
e-partners as companies attempt to stabilize their computer systems prior to
January 1, 2000 in order to reduce the risk of computer system problems
associated with the Year 2000 issue; its ability to scale its network and
operations to attract and support large numbers of e-seekers, e-partners,
suppliers and transactions; its ability to develop, introduce and market new
products and enhancements to its existing products on a timely basis; changes in
its pricing policies or those of its competitors; its ability to expand its
sales and marketing operations, including hiring additional sales personnel;
size and timing of sales of its products and services; success in maintaining
and enhancing existing relationships and developing new relationships with
Staples or other strategic partners (e-partners); compensation policies that
reward sales personnel based on achieving annual quotas; its ability to control
costs; technological changes in its markets; deferrals of e-partner alliances in
anticipation of service enhancements or new services; e-partner budget cycles
and changes in these budget cycles; seasonality; entry into the market of new
competitors; accounting standards and revenue recognition; fluctuations in
operating expenses; and general economic factors. In addition, because How2HQ's
increasing expense levels are based in part on expectations of its future
revenues, any decline in its revenues below its expectations would have a
disproportionately adverse impact on its operating results.
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HOW2HQ'S REBATE AND FULFILLMENT OPERATIONS HAVE ACCOUNTED FOR SUBSTANTIALLY ALL
OF ITS REVENUES AND GROSS MARGIN SINCE INCEPTION, AND HOW2HQ EXPECTS TO DEPEND
ON REBATE AND FULFILLMENT OPERATIONS FOR SUBSTANTIALLY ALL OF ITS REVENUES AND
GROSS MARGIN FOR THE FORESEEABLE FUTURE. Rebate and fulfillment and related
services accounted for substantially all of How2HQ's revenues since inception.
How2HQ anticipates that revenues from its rebate and fulfillment and related
services will continue to constitute substantially all of its revenues for the
foreseeable future. Consequently, a decline in demand for rebate and fulfillment
solutions, or failure to achieve broad market acceptance, would seriously harm
its business. How2HQ bills its rebate customers for the full amount of the
rebate checks that How2HQ issues to consumers. However, some consumers never
cash these rebate checks. Its agreements with its rebate customers generally
provide that How2HQ is entitled to retain the amounts paid to it by its rebate
customers even though the consumer never cashes the rebate check. In its
industry this is referred to as "slippage." The escheat laws of various states
provide that under certain circumstances holders of unclaimed property (possibly
including, under certain interpretations of such laws, slippage amounts) must
surrender that property to the state. Our quarterly operating results could
suffer if slippage decreases because more customers cash their rebate checks or
if a state claims that it is entitled to the slippage amounts as a result of the
unclaimed property or escheat laws of that state. In addition, a decline in the
amount of slippage that we retain could decrease our gross margins and
negatively impact our results of operations.
We depend on Staples and its vendors for a material portion of our business.
We depend upon our relationship with Staples and its vendors for a material
portion of our existing and anticipated business. We expect that we will
continue to depend upon Staples and its vendors for a material portion of our
initial offerings and 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 could suffer as a result of the termination of
our relationship with Staples or its vendors. In addition, there can be no
assurance that our relationship with Staples and its vendors will continue, or
if continued, will reach or exceed projected levels in any future period. The
initial term of our agreement with Staples is until July 2000. The agreement is
renewable annually upon mutual agreement between Staples and us. In addition,
Staples' vendors may not use or continue to use our rebate and fulfillment
services. Therefore, there can be no assurance that Staples, its vendors or any
of our customers will generate significant revenues in future periods. Our
future success will depend on our ability to obtain additional relationships
with retailers, vendors and businesses. The loss of all or any part of our
relationship with Staples or its vendors, or our failure to develop additional
relationships, would seriously harm our business, financial condition or results
of operations.
WE FACE POTENTIAL CONFLICTS OF INTERESTS RELATING TO CITADEL. Because of our
relationship with Citadel 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 the How2HQ service and business model in part. Mr. Steven
B. Solomon is the Chief Executive Officer and President of Citadel as well as
Founder, Chairman and Chief Executive Officer of How2HQ. In addition, Kenneth R.
Johnsen, its President and Chief Operating Officer, and Lawrence Lacerte, Victor
K. Kiam II, Mark Rogers, Chris A. Economou and Edward A. Pierce serve as
directors of both Citadel and How2HQ.
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Citadel also provided us with various services, including research and
development assistance; technical support and administrative services. Citadel
also subleases a portion of its Dallas, Texas facilities to us for the remaining
term of the lease. Citadel has also guaranteed our obligations under leases,
including our office space in Santa Monica, California, and our telephone
equipment lease.
Certain of our executive officers, key employees and directors also own, or
hold an option to purchase, equity securities of Citadel. Accordingly, conflicts
of interest may arise from time to time between Citadel and us particularly with
respect to the pursuit of overlapping corporate 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 Citadel and us. Directors may be
required to abstain from voting with respect to matters involving both Citadel
and our company. We could lose valuable management input from these directors
and officers who have conflicts.
IMPLEMENTATION OF ITS HOW2HQ.COM E-COMMERCE SOLUTIONS BY LARGE CUSTOMERS IS
COMPLEX, TIME CONSUMING AND EXPENSIVE. HOW2HQ EXPECTS TO EXPERIENCE LONG SALES
AND IMPLEMENTATION CYCLES. How2HQ's e-commerce solutions are often deployed with
many products offered by a manufacturer or retailer. Its implementation by large
organizations is complex, time consuming and expensive. In many cases, its
rebate customers 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 its services, including benefits, ease of use,
ability to work with existing systems, ability to support a larger rebate
customer base, functionality and reliability. Furthermore, How2HQ must educate
potential rebate customers on the use and benefits of its services. In addition,
How2HQ believes that the purchase of its services is often discretionary. It
frequently takes several months to finalize a sale and requires approval at a
number of management levels within the rebate customer organization. The
implementation and deployment of its services requires a significant commitment
of resources by its rebate customers and third-party manufacturers in the case
of retail rebate customers. Because How2HQ targets large rebate customers, its
sales cycles are typically long and as a result our business model may not be
successful.
HOW2HQ.COM'S BUSINESS IS VERY LABOR INTENSIVE. How2HQ.com depends on its ability
to recruit, hire, train and retain qualified employees and independent
contractors. A significant increase in its employee turnover rate could increase
its recruiting and training costs and decrease operating effectiveness and
productivity. Also, the addition of significant new customers or the
implementation of new high-volume programs may require it to recruit, hire and
train qualified personnel at an accelerated rate. How2HQ may not be able to
continue to hire, train and retain sufficient qualified personnel to adequately
staff its services in support of its
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customers' programs. Because labor costs are a significant portion of its costs,
an increase in wages, costs of employee benefits or employment could seriously
harm our business, results of operations or financial condition. In addition,
How2HQ's facilities are located in areas with relatively low unemployment rates,
and it is more difficult and costly to hire qualified personnel in these areas,
including Dallas, Los Angeles, Silicon Valley and Seattle.
HOW2HQ'S MARKETS ARE HIGHLY COMPETITIVE. The businesses in which How2HQ operates
are highly competitive and fragmented. How2HQ expects competition to persist and
to intensify in the future. Its rebate competitors include small firms offering
specific promotion fulfillment applications, divisions of larger entities and
large independent firms, such as Young America Corporation and , Continental
Promotions Group A number of competitors have or may develop greater
capabilities and resources than it. Similarly, additional competitors with
greater resources than it may enter this industry. Its performance and growth
could be harmed if its existing rebate customers decide to provide in-house
customer service operations that currently are outsourced or if potential rebate
customers retain or increase their in-house customer service operations or use
other providers. In addition, competitive pressures from current or future
competitors could cause its services to lose market acceptance or result in
significant price erosion. This could result in a material adverse effect upon
its business, results of operations or financial condition.
The market for our Internet tutorial, training, and How2 business and
content conversion services 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 web
sites offered by companies such as Learn2.com, Inc. and eHow, Inc., as well as
Internet portals, search engines or specific interest sites offered by companies
such as Ask Jeeves, Inc., Martha Stewart Living Omnimedia LLC, About.com, Inc.
and iVillage, Inc. In addition, because there are relatively low barriers to
entry in the online tutorial, content conversion and e-commerce markets, we
expect additional competition from other established and emerging companies, as
the markets continue to develop.
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 rebate customers and
have extensive knowledge of our industry. In the past, we have lost potential
rebate customers to competitors for various reasons, including lower prices and
other incentives not matched by us. 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 and services 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.
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HOW2HQ.COM'S BRAND MAY NOT ACHIEVE THE BROAD RECOGNITION NECESSARY TO SUCCEED.
How2HQ believes that a broad recognition and a favorable consumer perception of
the How2HQ.com brand are essential to its future success. Accordingly, How2HQ
intends to pursue an aggressive brand-enhancement strategy, which will include
mass market and multimedia advertising, promotional programs and public
relations activities. These initiatives will involve significant expense. If its
brand enhancement strategy is unsuccessful, these expenses may never be
recovered and How2HQ may be unable to increase future revenues. Successful
positioning of its brand will largely depend upon the quantity, quality and
timeliness of its tutorial content; the success of its advertising and
promotional efforts; and its ability to provide high quality customer service.
To increase awareness of its brand and expand it to a wide range of products and
services, How2HQ will need to spend significant amounts on advertising and
promotions. These expenditures may not result in a sufficient increase in
revenues to cover these advertising and promotions expenses. In addition, even
if brand recognition increases, the number of new users or the number of
transactions on the How2HQ.com service may not increase. Also, even if the
number of new users increases, those users may not use the How2HQ.com service on
a regular basis.
HOW2HQ DEPENDS UPON STRATEGIC ALLIANCES TO DEVELOP CONTENT FOR ITS WEB SITE,
SELL ITS SERVICES AND IMPLEMENT ITS TECHNOLOGY SOLUTIONS. How2HQ depends upon
third parties for several critical elements of its business, including content
development, product sales and technology. Some of its licensed content is
available from a limited number of sources. Although to date How2HQ has been
able to license or develop adequate tutorials, in the future we may not be able
to obtain sufficient content from third parties, or to develop our own content.
How2HQ depends on the quality and reliability of the licensed tutorials and the
timely delivery of those tutorials by its sources. How2HQ believes that it can
arrange alternate sources for some or all of the third party tutorials, but the
inability of any of these content providers to provide these tutorials to it on
a timely basis could affect the performance of its business. How2HQ currently
has strategic relationships with retailers and manufacturers who sell their
products through its How2HQ.com site. Its distribution arrangements typically
are not exclusive and may be terminated. There is no assurance that these
arrangements will result in revenues or be profitable for it. How2HQ has
contracted with third parties, and plans to continue to contract with third
parties, to manage, maintain and expand the computer and communications
equipment and software needed for the day-to-day operations of its How2HQ.com
web site. Examples of third parties with whom How2HQ has existing contractual
relationships include Exodus and Netscape. Third parties provide services to us
including the following: (1) managing the web server for the How2HQ.com web
site, (2) maintaining its communications lines (3) managing the network data
centers where its network data is stored and (4) integration and testing of the
compatibility of each web page on its web site. If these third parties do not
perform to its requirements, How2HQ would have to obtain similar services from
another provider or perform these functions internally. How2HQ 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 its How2HQ.com
web site, How2HQ may be entirely dependent on that party to manage, maintain and
provide security for it.
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IF HOW2HQ LOSES ITS KEY PERSONNEL OR CANNOT RECRUIT ADDITIONAL PERSONNEL, ITS
BUSINESS MAY SUFFER. Since its formation in January 1999, How2HQ has expanded
from one employee to more than 150 employees. How2HQ also has employed many key
personnel since its formation, including Steven B. Solomon, its Chairman and
Chief Executive Officer, Kenneth R. Johnsen, its President and Chief Operating
Officer, Juli Spottiswood, its Chief Financial Officer, Andrew F. Adams, its
Chief Technology Officer and other key managerial, marketing, planning,
financial, technical and operations personnel. How2HQ expects to continue to add
additional key personnel in the near future. How2HQ does not have "key person"
life insurance policies on any of its key personnel. Competition for key
personnel with experience in Internet commerce is also intense. How2HQ's future
success also depends on its continuing ability to attract, hire, train and
retain a substantial number of highly skilled managerial, technical, sales,
marketing and customer support personnel. How2HQ depends on hiring additional
personnel to increase its direct sales, research and application development
organizations. In addition, new hires frequently require extensive training
before they achieve desired levels of productivity. Competition for qualified
personnel is intense, and How2HQ may fail to retain its key employees or to
attract or retain other highly qualified personnel. How2HQ's business would be
negatively impacted if we were to lose the services of these employees or fail
to hire qualified new personnel.
IN ORDER TO MANAGE ITS GROWTH AND EXPANSION, HOW2HQ WILL NEED TO IMPROVE AND
IMPLEMENT NEW SYSTEMS, PROCEDURES AND CONTROLS. How2HQ has recently experienced
a period of significant expansion of its operations that has placed a strain
upon its management systems and resources. If How2HQ is unable to manage its
growth and expansion, its business will be seriously harmed. In addition, How2HQ
has recently hired a significant number of employees and plans to further
increase its total headcount. How2HQ also plans to expand the geographic scope
of its rebate customer base and operations. This expansion has resulted and will
continue to result in substantial demands on its management resources. Its
ability to compete effectively and to manage future expansion of its operations,
if any, will require it to continue to improve its financial and management
controls, reporting systems and procedures as well as expand, train and manage
its employee work force. How2HQ is currently implementing new systems to manage
its financial and human resources infrastructure. Even after How2HQ implements
these systems, its personnel, systems, procedures and controls may be inadequate
to support its future operations.
HOW2HQ MAY NOT BE ABLE TO INTEGRATE THE OPERATIONS FROM ITS RECENT ACQUISITIONS.
How2HQ recently acquired the Forward Companies and 2-Lane Media, Inc. as well as
substantially all of the content conversion and multimedia production assets of
Broadcast Production Group (BPG Worldwide). How2HQ may have difficulty in
assimilating the personnel, operations, technology and software of these
operations. In addition, key personnel of the acquired companies may decide not
to continue to work for it. This could disrupt its ongoing business, distract
its management and employees and increase its expenses.
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HOW2HQ MAY NEED TO CONTINUE TO MAKE ACQUISITIONS IN ORDER TO REMAIN COMPETITIVE
IN ITS MARKET. ITS BUSINESS COULD BE ADVERSELY AFFECTED AS A RESULT OF ANY OF
THESE FUTURE ACQUISITIONS. Since its formation in January 1999, How2HQ has
completed the acquisitions of two companies and substantially all of the content
conversion and multimedia production assets of a third company. In order to
obtain content or other resources or to otherwise remain competitive, How2HQ may
find it necessary to acquire additional businesses, products or technologies. If
How2HQ identifies an appropriate acquisition candidate, How2HQ may not be able
to negotiate the terms of the acquisition successfully, finance the acquisition,
or integrate the acquired business, products or technologies into its existing
business and operations. Further, completing a potential acquisition and
integrating the acquired businesses will cause significant diversions of
management time and resources. In addition to the acquisitions How2HQ has
completed, if How2HQ consummates one or more additional significant acquisitions
in which the consideration consists of stock or other securities, its equity
could be significantly diluted. If How2HQ were to proceed with one or more
significant acquisitions in which the consideration included cash, How2HQ could
be required to use a substantial portion of its available cash to consummate any
acquisition. Acquisition financing may not be available on favorable terms, or
at all. In addition, How2HQ may be required to amortize significant amounts of
goodwill and other intangible assets in connection with past and future
acquisitions, which will adversely affect its results of operations.
HOW2HQ MAY BE SUED FOR INFORMATION RETRIEVED FROM ITS WEB SITE. How2HQ may be
subject to claims for defamation, negligence, copyright or trademark
infringement, personal injury or other legal theories relating to the
information How2HQ publishes on its web site. These types of claims have been
brought, sometimes successfully, against online services as well as other print
publications in the past. How2HQ could also be subjected to claims based upon
the content that is accessible from its web sites through links to other web
sites or through content and materials that may be posted by members in chat
rooms or bulletin boards. How2HQ may also offer e-mail services, which may
subject it to potential risks, such as liabilities or claims resulting from
unsolicited e-mail, lost or misdirected messages, illegal or fraudulent use of
e-mail or interruptions or delays in e-mail service. Its insurance, which covers
commercial general liability, may not adequately protect it against these types
of claims.
HOW2HQ COULD BE SUBJECT TO LAWSUITS OR CLAIMS RELATED TO PRODUCTS AND SERVICES
OFFERED THROUGH THE HOW2HQ.COM WEB SITE. Consumers may sue How2HQ if any of the
products or services that How2HQ or its partners sell online are defective, fail
to perform properly or injure the user. To date, How2HQ has had very limited
experience in the sale of products online and the development of relationships
with manufacturers or suppliers of these products. How2HQ plans to develop a
range of products targeted specifically at e-seekers through its tutorial web
sites and other e-commerce web sites that How2HQ may acquire in the future.
How2HQ also may foster relationships with manufacturers or companies to offer
these products directly on its web site. This strategy involves numerous risks
and uncertainties. Any errors, defects or other performance problems could
result in financial or other damages to e-seekers. A product liability or other
claim brought against How2HQ, even if not successful, would likely be time
consuming and costly and could seriously harm its business. Liability claims
could require it 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 its reputation and its business.
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IF THE PROTECTION OF ITS INTELLECTUAL PROPERTY IS INADEQUATE, ITS COMPETITORS
MAY GAIN ACCESS TO ITS TECHNOLOGY, AND HOW2HQ MAY LOSE CUSTOMERS. How2HQ depends
on its ability to develop and maintain the proprietary aspects of its
technology. To protect its proprietary technology, How2HQ relies primarily on a
combination of contractual provisions, confidentiality procedures, trade
secrets, and patent, copyright and trademark laws. How2HQ seeks to avoid
disclosure of its trade secrets through a number of means, including but not
limited to, requiring those persons with access to its proprietary information
to execute confidentiality agreements with it and restricting access to its
source code. How2HQ seek to protect its software, documentation and other
written materials under trade secret and copyright laws, which afford only
limited protection. How2HQ cannot assure you that any of its proprietary rights
with respect to its How2HQ.com web site 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 How2HQ has filed a provisional patent application with respect to
its rebate e-commerce applications, How2HQ has been issued no patents, and none
may be issued from its existing provisional patent application. Its future
patents, if any may be successfully challenged or may not provide it with any
competitive advantages. In addition, How2HQ may not develop proprietary products
or technologies that are patentable and other parties may have prior claims.
Despite its efforts to protect its proprietary rights, unauthorized parties
may attempt to copy aspects of its products or to obtain and use information
that How2HQ regard as proprietary. Policing unauthorized use of its products is
difficult, and while How2HQ is unable to determine the extent to which piracy
exists, piracy can be expected to be a persistent problem. In addition, the laws
of some foreign countries do not protect its proprietary rights to as great an
extent as do the laws of the United States. Its means of protecting its
proprietary rights may not be adequate and its competitors may independently
develop similar technology, duplicate its products or design around patents
issued to it or its 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 How2HQ or its current or potential future products or
services infringe their intellectual property. How2HQ expects that developers
and providers of e-commerce solutions will increasingly be subject to
infringement claims as the number of products and competitors in its 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 its services or require it
to enter into royalty or licensing agreements. Royalty or licensing agreements,
if required, may not be available on terms acceptable to it, which could
seriously harm its business.
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HOW2HQ IS DEPENDENT ON ITS DOMAIN NAMES, AND HOW2HQ COULD SUFFER LOSSES IF ITS
DOMAIN NAMES ARE NOT PROTECTED. How2HQ currently holds the Internet domain name
"www.how2hq.com," as well as various other related names. Domain names generally
are regulated by 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, How2HQ may not acquire or maintain the "www.how2hq.com" domain name in
all of the countries in which How2HQ conduct business.
The relationship between regulations governing domain names and laws
protecting trademarks and similar proprietary rights is unclear. Therefore,
How2HQ could be unable to prevent third parties from acquiring domain names that
infringe or otherwise decrease the value of its trademarks and other proprietary
rights.
ITS BUSINESS COULD BE ADVERSELY AFFECTED IF THE SYSTEMS HOW2HQ USES ARE NOT YEAR
2000 COMPLIANT OR IF ITS CUSTOMERS OR POTENTIAL CUSTOMERS ALTER THEIR PURCHASING
PATTERNS AS A RESULT OF THE YEAR 2000 PROBLEM. The risks posed by Year 2000
issues could adversely affect its business in a number of significant ways.
Although How2HQ believes that its internally developed systems and technology
are Year 2000 compliant, its information technology systems nevertheless could
be substantially impaired or cease to operate due to Year 2000 problems.
Additionally, How2HQ relies on information technology supplied by third parties,
and its participating sellers also are heavily dependent on information
technology systems and on their own third-party vendor systems. Year 2000
problems experienced by it or any of these third parties could materially affect
its business. Additionally, the Internet could face serious disruptions arising
from the Year 2000 problem. How2HQ cannot guarantee that any of its
participating e-partners or other Internet vendors will be Year 2000 compliant
in a timely manner, or that there will not be significant interoperability
problems among information technology systems. How2HQ also cannot guarantee that
e-seekers and e-partners will be able to use its web site without serious
disruptions arising from the Year 2000 problem. Given the pervasive nature of
the Year 2000 problem, How2HQ cannot guarantee that disruptions in other
industries and market segments will not adversely affect its business. Moreover,
its costs related to Year 2000 compliance, which thus far have not been
material, could ultimately be significant. In the event that How2HQ experiences
disruptions as a result of the Year 2000 problem, its business could be
seriously harmed.
CAPACITY CONSTRAINTS AND SYSTEM FAILURES COULD HARM ITS BUSINESS. If How2HQ
cannot expand its systems to cope with increased demand, or its systems
otherwise fail to perform, How2HQ could experience unanticipated disruptions in
service; slower response times; decreased e-seeker service and satisfaction; or
delays in the introduction of new products and services. Any of these factors
could impair its reputation, damage the How2HQ.com brand and harm our business,
results of operations and financial condition.
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How2HQ uses internally developed and third party systems to operate the
How2HQ.com web site, including transaction processing and order management
systems that were designed to be scalable. However, if the number of users of
the How2HQ.com service increases substantially, How2HQ will need to
significantly expand and upgrade its technology, transaction processing systems
and network infrastructure. How2HQ does not know whether How2HQ will be able to
accurately project the rate or timing of any increases, to allow it to upgrade
its 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 the How2HQ.com web site.
Each of these has experienced significant outages in the past and could
experience outages, delays and other difficulties due to system failures
unrelated to its systems. Any delays in response time or performance problems
could cause e-seekers to perceive How2HQ's web site as not functioning properly
and therefore cause them to use other web sites.
Its ability to facilitate transactions successfully and provide high quality
e-seeker service also depends on the efficient and uninterrupted operation of
its computer and communications hardware systems. The How2HQ.com service may
experience periodic system interruptions from time to time. Its systems and
operations also are 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 establish redundant servers to provide limited service during system
disruptions, How2HQ does not have fully redundant systems, a formal disaster
recovery plan or alternative providers of hosting services. In addition, How2HQ
does not carry sufficient business interruption insurance to compensate for
losses that could occur. Any system failure that causes an interruption in
service or decreases the responsiveness of the How2HQ.com service could impair
its reputation, damage its brand name and materially adversely affect its
revenues.
Its business is highly dependent on its computer and telephone equipment and
software systems. While How2HQ maintain backup systems, the temporary or
permanent loss of any of these equipment or systems, through casualty loss due
to factors such as fire, flood, earthquake or tornado, or operating malfunction,
could seriously harm its business. While How2HQ has property and business
interruption insurance, its insurance may not adequately compensate it for all
losses.
ABANDONED PROPERTY LAWS MAY REQUIRE HOW2HQ TO SURRENDER UNCLAIMED REBATE
PAYMENTS TO A STATE. The unclaimed property (or escheat) laws of each state
provide that under circumstances defined in the state's statutes, holders of
unclaimed property (possibly including the rebate checks that consumers do not
cash, also called slippage) must surrender that property to the state. As a
result, a state could assert that it is entitled to unclaimed rebate checks that
How2HQ has issued to consumers which could harm its business, results of
operations and financial condition. In addition, the escheat laws are uncertain
and may change. Also, those states may seek to require its rebate customers to
surrender the slippage amounts to the states and
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any other state may be successful in any action under its escheat laws to
require How2HQ to surrender to it slippage amounts unclaimed by residents of
that state. The escheat laws are uncertain and may change, How23HQ's
interpretation of escheat laws may not prevail in any action by a state to
recover any slippage amounts, a state may seek to require its rebate customers
to surrender the slippage amounts to them, or a state may be successful in an
action under its escheat laws to require it to surrender to it slippage amounts
unclaimed by residents of that state. Any such actions could have a material
adverse effect on How2HQ's business, results of operations, and financial
condition.
HOW2HQ DEPENDS 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, ITS BUSINESS WILL BE MATERIALLY ADVERSELY AFFECTED. Its How2HQ.com
web site depends 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 continue to develop at historical rates and
a sufficiently broad base of e-seekers may not adopt or continue to use 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.
How2HQ's business would be materially adversely affected if use of the
Internet and other online services does not continue to increase or increases
more slowly than expected; the technology underlying the Internet and other
online services does not effectively support any expansion that may occur; or
the Internet and other online services do not create a viable commercial
marketplace, inhibiting the development of e-commerce and reducing the need for
How2HQ's products and services.
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; and increased governmental regulation.
INCREASED GOVERNMENT REGULATION COULD LIMIT THE MARKET FOR, OR IMPOSE SALES AND
OTHER TAXES ON THE SALE OF, ITS PRODUCTS AND SERVICES, OR ON PRODUCTS AND
SERVICES PURCHASED THROUGH ITS HOW2HQ.COM WEB SITE. As Internet commerce
evolves, How2HQ expects 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 its products and services.
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<PAGE> 38
How2HQ does not collect sales or other similar taxes for goods and services
purchased through its How2HQ.com web site. However, one or more states may seek
to impose sales tax collection obligations on out-of-state companies like it
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 its
opportunity to derive financial benefit from such activities. Moreover, a
successful assertion by one or more states or any foreign country that How2HQ
should collect sales or other taxes on the exchange of goods and services
through its How2HQ.com web site could seriously harm its business.
Legislation limiting the ability of the states to impose taxes on
Internet-based transactions has been proposed in the U.S. Congress. This
legislation could ultimately be enacted into law or this legislation could
contain a limited time period when this tax moratorium will apply. In the event
that the tax moratorium is imposed for a limited time period, the legislation
could be renewed at the end of this period. Failure of Congress to enact or
renew this legislation could allow various states to impose taxes on e-commerce,
and the imposition of these taxes could seriously harm its business.
ONLINE SECURITY BREACHES COULD HARM ITS BUSINESS. The secure transmission of
confidential information over the Internet is essential in maintaining consumer
and supplier confidence in the How2HQ service. Substantial or ongoing security
breaches of its system or other Internet-based systems could significantly harm
its business. How2HQ will require buyers to guarantee their offers with their
credit card, either online or through its toll-free telephone service. It relies
on licensed encryption and authentication technology to effect secure
transmission of confidential information, including credit card numbers. 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 it
to protect e-seeker transaction data. 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 its
systems or those of its e-seekers, e-partners or suppliers, which could disrupt
its How2HQ.com web site or make it inaccessible to e-seekers, e-partners or
suppliers.
How2HQ incur substantial expense to protect against and remedy security
breaches and their consequences. A party that is able to circumvent its security
systems could steal proprietary information or cause interruptions in its
operations. Security breaches also could damage its reputation and expose it to
a risk of loss or litigation and possible liability. Its insurance policies
limits may not be adequate to reimburse it for losses caused by security
breaches. How2HQ cannot guarantee that its security measures will prevent any
potential security breaches.
How2HQ 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, the How2HQ.com service
as a means of conducting commercial transactions.
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<PAGE> 39
HOW2HQ IS HEAVILY DEPENDENT ON TELEPHONE, POSTAL AND DELIVERY SERVICES. How2HQ
materially relies on services provided by various local and long distance
telephone companies in connection with its rebate and fulfillment business. A
significant increase in the cost of telephone services or any significant
interruption in telephone services, could have a material adverse affect on its
business. Its 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 its mailings and shipments to
consumers. How2HQ benefit from discounts from the basic postal rate structure,
such as discounts for bulk mailings and pre-sorting by zip code and carrier
routes. Any increase in postal and other delivery service rates, including the
elimination of existing discounts, could have a material adverse affect on its
business. From time to time, the United States postal rate may increase.
HOW2HQ HAS IMPLEMENTED ANTI-TAKEOVER PROVISIONS THAT COULD MAKE IT MORE
DIFFICULT FOR A THIRD PARTY TO ACQUIRE IT. Some provisions of How2HQ's
certificate of incorporation and bylaws, as well as some provisions of Delaware
law, could make it more difficult for a third party to acquire it, even if doing
so would be beneficial to its stockholders. These provisions may also discourage
possible acquirers from even considering acquiring it.
ITS EXISTING EXECUTIVE OFFICERS, DIRECTORS AND PRINCIPAL STOCKHOLDERS CONTROL IT
AND COULD LIMIT THE ABILITY OF ITS OTHER STOCKHOLDERS TO INFLUENCE THE OUTCOME
OF DIRECTOR ELECTIONS AND OTHER TRANSACTIONS SUBMITTED FOR A VOTE OF ITS
STOCKHOLDERS. How2HQ, its executive officers, directors and principal
stockholders, including Citadel, will beneficially own, in the aggregate, in
excess of 50% of its outstanding common stock. Citadel owns 20,000,000 shares of
its common stock. As a result, these stockholders will be able to exercise
control over all matters requiring stockholder approval, including the election
of directors and approval of significant corporate transactions that could have
the effect of delaying or preventing a third party from acquiring control over
it.
HOW2HQ DOES NOT ANTICIPATE PAYING DIVIDENDS IN THE NEAR FUTURE. How2HQ has never
declared or paid a cash dividend on its common stock. How2HQ does not anticipate
paying cash dividends on its common stock in the foreseeable future.
39
<PAGE> 40
RESULTS OF OPERATIONS
NET REVENUE
During the three months ended May 31, 1999, the Company had net sales of
$1,592,485, an increase of $558,290, or 54.0%, over net sales of $1,034,195
during the three months ended May 31, 1998. The Company attributes the sales
increase to its How2HQ subsidiary, which acquired 2-Lane Media, Inc. ("2-Lane'),
a web site and e-commerce design company, and The Forward Companies ("Forward"),
a rebate/order fulfillment company. Net sales for the 1999 period for How2HQ
were $1,391,912. The sales attributed to the Company's software products
declined from $1,034,195 to $200,573, or a decrease of $833,622, or 80.5%. The
Company attributes the decrease in its software product revenue 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. 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.
The Company completed beta testing its new WinShield Secure PC product and
launched this product in August 1999. The Company also expects to launch other
new products and upgrades in the future quarters of fiscal 2000 that will
provide ease-of-use security solutions for Internet and intranet applications on
Microsoft and Novell platforms.
COST OF SALES
The costs and expenses incurred in connection with producing the Company's
products were $937,918 during the quarter, an increase of $867,587, or 1,233.6%,
over cost of sales of $70,331 for the same period last year. As a percentage of
sales, the Company's cost of sales for the quarter increased from 6.8% for the
three months ended May 31, 1998 to 58.9% for the three months ended May 31,
1999. The increase in cost of sales for the current quarter over the same
quarter last year can be attributed to the results of operations of How2HQ.
Costs and expenses for How2HQ were $911,997, or 65.5% of sales, due to the
higher costs of sales related to the rebate and fulfillment operations. The
actual cost of sales attributed to the Company's software products decreased to
$25,921, or 12.9% of software sales, for the quarter ended May 31, 1999 from
$70,331, or 6.9% of software sales, for the same quarter last year. The increase
as a percentage of sales resulted from a decrease in the average order size this
quarter over the same period last year, which resulted from a reduction in
distributor sales this quarter over the same period last year.
40
<PAGE> 41
RESEARCH AND DEVELOPMENT EXPENSE
Research and development costs charged to expense for the quarter were $303,076
versus $104,724 for the same period last year, or an increase of $198,352, or
189.4%. Research and development costs of approximately $130,000 and $500,000
for the quarters ended May 31, 1999 and 1998, respectively were capitalized.
Research and development cost charged to expense related to the Company's
software products were $150,583 for the quarter versus $104,724 for the same
quarter last year. The remaining costs charged to development expense during the
quarter related to development cost of How2HQ of $152,493. The increase in the
software development costs charged to expense during the quarter relates to the
Company performing more non-capitalizable development activities this quarter
compared to the same period this year. The decrease in the costs capitalized
during the quarter related primarily to a decrease in the level of development
work being performed by outside contract consultants during the current quarter
when compared to the same quarter last 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 it during August 1999. Secure PC was originally scheduled for beta
testing in April 1999, but was delayed due to enhancements of the product. The
Company plans to continue to develop its new products and upgrades and
enhancement internally for at least the remainder of the year. 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 increased from $471,394 for the quarter ended May
31, 1998 to $1,282,835 for the quarter ended May 31, 1999, an increase of
$811,441 or 172.1%. As a percentage of sales, selling and marketing expenses for
the quarter increased from 45.6% to 80.6%. Selling and marketing expenses by
company are as follows (i) Citadel $1,083,996,or 540.4% of sales, and (ii)
How2HQ $198,840, or 14.3% of sales.
As noted above, the Company's selling and marketing expenses related to its
software products increased from $471,394, or 45.6%, of sales for the three
months ended May 31, 1998 to $1,083,996, or 540.4% of sales, for the three
months ended May 31, 1999. During the last two quarters, 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
are front-loaded, i.e., the costs are recognized now, while the benefits are not
expected to be derived until future quarters. The Company does not feel that
current quarter's costs are indicative of what the cost will be in future
quarters. The Company plans, in the future, to do more sales specific marketing
and less general marketing. Therefore, the Company anticipates that these
expenses will be reduced both on a dollar and percentage basis in future
quarters. 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.
41
<PAGE> 42
While the Company does not anticipate that its selling and marketing expenses
related to its software products will increase in future quarters, it does
expect that the selling and marketing expenses related to How2HQ will increase
significantly.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses increased $351,292, or 98.9% from $355,339
for the quarter ended May 31, 1998 to $706,631 for the quarter ended May 31,
1999. This resulted primarily from the addition of How2HQ and its acquisitions,
which increased general and administrative expenses by $451,404 during the
quarter. General and administrative expenses, during the quarter, associated
with the Company's software products declined $100,112 from the same period last
year. This can be attributed to the Company's restructuring and cost control
programs implemented during the previous fiscal year. As a percentage of sales
these expenses increased from 34.4% in 1998 to 44.4% in 1999. The increase in
the percentage is the result of the general and administrative expenses
increasing greater on a consolidated basis than did the consolidated revenues
(98.9% versus 54.4%), which related to the addition of How2HQ.com and its
acquisitions. The Company would expect that as it continues to develop How2HQ,
these expenses, on a consolidated basis, would continue to increase.
DEPRECIATION AND AMORTIZATION EXPENSE
Depreciation and amortization expense increased $167,277, or 47.5%, to $519,703
from $352,426 for the three months ended May 31, 1999 and 1998, respectively.
This increase resulted from the depreciation and amortization expense associated
with How2HQ this quarter. The Company would expect that these expenses will be
higher in succeeding quarters due to the amortization of goodwill associated
with How2HQ's acquisition of 2-Lane and Forward. During the last quarter of the
previous fiscal year, the Company wrote-off approximately $1,200,000 of
purchased software costs. This write-off had the impact of reducing the
depreciation and amortization expense in the current quarter by approximately
$125,000.
OTHER INCOME (EXPENSE)
During the quarter the Company provided an additional reserve of $25,000 related
to the settlement of certain lawsuits. The Company will continue to evaluate its
reserves relating to this issue and will provide an adjustment as it considers
necessary. Interest expense for the three months ended May 31, 1999 decreased to
$11,478, a decrease of $39,726, or 77.6%, over net interest expense of $51,204
during the same period last year. This resulted primarily from the Company
having less interest bearing debt during this quarter than during the quarter
ended May 31, 1998. Other income of $28,276 during the quarter ended May 31,
1999 primarily represents interest income received on interest bearing deposits
during the quarter.
OPERATING LOSS BEFORE MINORITY INTEREST AND EXTRAORDINARY ITEM As a result of
the foregoing the Company, for the three months ended May 31, 1999 reported a
net loss before minority interest and extraordinary items of $2,165,880,
compared to a net loss of $371,223 for the same period last year.
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<PAGE> 43
EXTRAORDINARY ITEM - FORGIVENESS OF DEBT
During the quarter ended May 31, 1998, the Company recognized a gain on the
settlement of debts of $527,221 relating primarily to the restructuring of a
certain note payable to Inxight, a division of Xerox. In connection with the
restructuring, Inxight agreed to reduce a certain note and accrued interest due
from the Company by $520,816. In exchange the Company agreed to a shorter
maturity on the note and the issuance of 250,000 shares of the Company's common
stock to Inxight (valued at $92,500 as of the date of the transaction). The
value of the stock 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 quarter.
NET LOSS
As a result of the aforementioned, the Company, for the three months ended May
31, 1999, reported a net loss of $1,882,869, compared to a net profit of
approximately $155,998 for the same period last year.
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.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash and cash equivalents at May 31, 1999 were $7,635,010 on a
consolidated basis, which included $6,670,792 of cash and cash equivalents of
How2HQ.
Cash flows from operations were a negative $2,892,394 for the three months ended
May 31, 1999, compared to negative $772,821 for the three months ended May 31,
1998. This decrease was primarily due to an increase in the Company's net loss
for the period and a reduction in accounts payable and accrued expenses.
43
<PAGE> 44
Cash used in investing activities was approximately $5,338,453 for the three
months ended May 31, 1999, compared to approximately $507,872 for the same
period last year. This increase was due the acquisition of 2-Lane and Forward by
the Company's subsidiary, How2HQ.
Cash flows provided by financing activities were $12,479,488 for the three
months ended May 31, 1999, compared to $2,519,707 for the three months ended May
31, 1998. This increase was due primarily to the proceeds realized from the sale
by How2HQ of shares of its common stock during the quarter.
As a result of the aforementioned factors, cash and cash equivalents increased
by $4,248,641 for the three months ended May 31, 1999, versus an increase of
approximately $1,239,014 for the same period last year.
Subsequent to the end of the quarter, How2HQ issued 585,000 shares (post split)
of its common stock pursuant to private placements to accredited investors under
Section 4(2) under the Securities Act for commitments for proceeds of
$2,850,000.
44
<PAGE> 45
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
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 to talk with that purpose in mind.
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.
45
<PAGE> 46
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, How2HQ, issued 1,188,251 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 $8,710,500.
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Ex - 27 Financial Data Schedule
REPORTS ON FORM 8-K.
The Company filed no Current Reports on Form 8-K during the quarter ended May
31, 1999. Subsequent to the end of the quarter, on June 3, 1999, the Company
filed a Current Report on Form 8-K relating to its acquisition of the Forward
Companies.
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.
46
<PAGE> 47
CITADEL TECHNOLOGY, INC.
(REGISTRANT)
Date: September 24, 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)
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<PAGE> 48
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Exhibit No. 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 THREE
MONTHS ENDED MAY 31, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
CONSOLIDATED FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> FEB-28-2000
<PERIOD-START> MAR-01-1999
<PERIOD-END> MAY-31-1999
<CASH> 7,635,010
<SECURITIES> 0
<RECEIVABLES> 5,906,491
<ALLOWANCES> 1,275,000
<INVENTORY> 146,764
<CURRENT-ASSETS> 16,071,930
<PP&E> 2,178,869
<DEPRECIATION> 1,060,169
<TOTAL-ASSETS> 33,760,156
<CURRENT-LIABILITIES> 10,753,415
<BONDS> 204,501
21
0
<COMMON> 451,420
<OTHER-SE> 12,872,174
<TOTAL-LIABILITY-AND-EQUITY> 33,760,156
<SALES> 1,592,485
<TOTAL-REVENUES> 1,592,485
<CGS> 937,918
<TOTAL-COSTS> 937,918
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 11,478
<INCOME-PRETAX> (1,882,869)
<INCOME-TAX> 0
<INCOME-CONTINUING> (1,882,869)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (1,882,869)
<EPS-BASIC> (.05)
<EPS-DILUTED> (.05)
</TABLE>
