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U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-KSB
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
For the fiscal year ended June 30, 2000
OR
[ ] 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 1-13760
THE NETWORK CONNECTION, INC.
(Name of Small Business Issuer in Its Charter)
GEORGIA 58-1712432
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
1811 CHESTNUT STREET, SUITE 110
PHILADELPHIA, PENNSYLVANIA 19103
(Address of Principal Executive Offices)
(215) 832-1046
(Issuer's Telephone Number, Including Area Code)
Securities registered under Section 12(b) of the Exchange Act:
Name of Each Exchange
Title of Each Class on Which Registered
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Common Stock, $0.001 par value per share The Nasdaq SmallCap Market
Securities registered under Section 12(g) of the Exchange Act: None
Check whether the issuer: (1) 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 that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.Yes [X] No [ ]
Check if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of the registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [ ]
Issuer's revenues for its most recent fiscal year: $7,091,660
As of September 25, 2000, the number of shares of Common Stock outstanding
was 19,973,117 and the aggregate market value of such Common Stock (based on the
closing sales price of the Common Stock on such date as reported by the Nasdaq
SmallCap Market) held by non-affiliates was approximately $20,226,221.
Transitional Small Business Disclosure Format: Yes [ ] No [X]
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DOCUMENTS INCORPORATED BY REFERENCE
Part III incorporates information by reference from portions of TNCi's
definitive proxy statement for its 2000 Annual Meeting of Shareholders scheduled
to be held on Thursday, November 16, 2000 (the "Proxy Statement"). With the
exception of those portions which are expressly incorporated by reference, the
Proxy Statement is not deemed filed as a part of this Annual Report.
REFERENCES AND FORWARD-LOOKING STATEMENTS
References made in this Annual Report on Form 10-KSB to "TNCi," the
"Company" or the "Registrant" refer to The Network Connection, Inc. and its
subsidiary. AirView, Cheetah, Cheetah Workgroup, CruiseView, EduView, InnView,
M2, M2V, Quad-Cheetah, T.R.A.C., The Network Connection, TNX, TrainView,
TransPORTAL, Triumph, the TNCi logo are trademarks of TNCi.
This Annual Report on Form 10-KSB contains forward-looking statements. In
some cases, readers can identify forward-looking statements by terminology such
as "may," "will," "should," "could," "expects," "plans," "anticipates,"
"believes," "estimates," "predicts," "potential," or "continue." These
statements involve known and unknown risks, uncertainties and other factors that
may cause TNCi's actual results, performance, or achievements to be materially
different from those stated herein. Although management of TNCi believes the
expectations reflected in the forward-looking statements are reasonable, the
Company cannot guarantee future results, performance, or achievements. Factors
that could cause actual results to differ materially include, but are not
limited to, the risks detailed below and included from time to time in the
Company's other SEC reports and press releases, copies of which are available
from the Company upon request. The Company assumes no obligation to update any
forward-looking statements contained herein.
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THE NETWORK CONNECTION, INC.
ANNUAL REPORT ON FORM 10-KSB
TABLE OF CONTENTS
Page
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PART I.........................................................................2
ITEM 1 - DESCRIPTION OF BUSINESS............................................2
ITEM 2 - DESCRIPTION OF PROPERTY...........................................10
ITEM 3 - LEGAL PROCEEDINGS.................................................11
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............12
PART II.......................................................................13
ITEM 5 - MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS..........13
ITEM 6 - MANAGEMENT'S DISCUSSION AND ANALYSIS or plan OF OPERATION.........13
ITEM 7 - FINANCIAL STATEMENTS..............................................24
ITEM 8 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE..........................................24
PART III......................................................................25
ITEM 9 - DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT.................25
ITEM 10 - EXECUTIVE COMPENSATION............................................25
ITEM 11 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT....25
ITEM 12 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....................25
ITEM 13 - EXHIBITS AND REPORTS ON FORM 8-K..................................25
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PART I
ITEM 1 - DESCRIPTION OF BUSINESS
GENERAL
The Network Connection is a pioneer in bringing broadband, all-digital
entertainment and information solutions to the "away-from-home" marketplace. Our
solutions are designed to deliver customized interactive services such as
digital movies, video-on-demand, e-commerce, Internet/Intranet access, laptop
connectivity, video-based training, advertising, Internet protocol (IP) IP
telephony, and other IP-based services. Our platform is based on the same
standards that power the Internet today, providing the ability to scale and
expand our solutions along with industry advancements. Each installation is
based on the same advanced system architecture, allowing us to easily upgrade
and expand the services available over time.
We are a leader in developing and deploying these all-digital solutions,
and our technology has been selected and installed in hotels, cruise ships,
educational facilities, and in a railway simulator car in Europe.
We have had the following recent developments:
* EXECUTIVE MANAGEMENT - In March 2000, we announced the appointment of
a new executive management team, including Robert S. Pringle,
President and Chief Operating Officer, Dr. Jay R. Rosan, Executive
Vice President, and Richard E. Genzer, Chief Technology Officer. These
well-regarded Internet executives have broad experience in building
branded Internet portals, creating successful e-commerce solutions,
and aggregating information and entertainment content.
* SYSTEM DEPLOYMENT - In September 2000, we announced a relationship
with Comdisco (NYSE:CDO), enhancing our capability to manage system
installation, monitoring and deployment on a global basis.
* CONTENT DIVISION - In March 2000, we formed a new division to focus on
creating long-term business models for content, commerce, community
and connectivity. This division will create an enhanced away-from-home
experience where people can access and customize content and data.
Richard Gallagher was hired in August 2000 to lead this division.
* HOTEL & HOSPITALITY DIVISION - Our technology is currently installed
in approximately 800 guest rooms, and we have signed contracts to
install the technology in over 2,000 additional guest rooms for a
total contractual base of 2,500 guest rooms. Our InnView(TM) system
has been well received in the marketplace, and we expect our progress
in this marketplace to continue to accelerate given our initial
successful implementations.
* CRUISE SHIP DIVISION - We have developed an enhanced version of our
CruiseView technology platform, increasing its performance and
capabilities, and are in advanced discussions with several major
cruise companies about installing this interactive system, including
Carnival. We have terminated our prior contract with Carnival Cruise
Lines, through a mutual release which allows us to retain our
equipment and retain approximately $1.6 million in cash advances. We
continue to operate our CruiseView(TM)system on one 1,040-cabin
Carnival ship while we negotiate the terms of a potential
forward-looking agreement to deploy our latest CruiseView(TM)solution.
* EDUCATION & CORPORATE TRAINING DIVISION - In September 1999, we
completed delivery and installation of 195 Cheetah video servers to
Georgia schools in connection with the Georgia Metropolitan Regional
Education Services Agency (MRESA) Net 2000 project. We received
payment of $5.4 million in connection with the project. We have
developed a national network of leading technology integrators for the
educational marketplace, and have submitted several significant
proposals for new business in this area.
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* PASSENGER RAIL DIVISION - In September 1999, we hired Stephen J.
Ollier to lead the division. We have submitted pricing proposals to
two of the world's largest train operators for new and retrofit
installations of TrainView systems. We launched our new
PROJECTRAINBOW(TM) showroom and demonstration system in June in the
United Kingdom. We have entered into advanced discussions with leading
railway operators in the United Kingdom to outfit our system on their
fleets.
Guest Services available through our CruiseView and InnView Systems
include:
* on-demand films, short video features and music videos;
* free-to-guest television programs;
* concierge information and reservations;
* in-room guest messaging and bulletin boards; and
* in-room folio review, express check-out and guest surveys.
Eventually, we also plan to include the following guest services through
our systems:
* high-speed access to the World Wide Web and e-mail;
* voice-over IP (i.e., long distance telephone calls over the Internet);
* e-commerce services, such as interactive shopping;
* interactive games and casino-style gambling where permitted by law;
and
* interactive advertising and promotion of customer events, shops and
restaurants.
BUSINESS STRATEGY
Our primary objective is to be a leading provider of broadband solutions
for the away-from-home marketplace. To this end, we have developed the following
strategies:
* DEPLOY, OWN, AND OPERATE BROADBAND NETWORKS ACROSS MULTIPLE SEGMENTS
OF THE AWAY-FROM-HOME MARKETPLACE. We provide both infrastructure and
programming, retaining the long-term rights to deliver services over
our broadband networks. Our business model balances shared up-front
capital investment with shared long-term revenue streams.
* BE RECOGNIZED AS A TOTAL SOLUTION PROVIDER. We will continue to
develop our content division, which will acquire, package and monitor
a broad range of compelling multimedia content tailored to appeal to
the typical end-users in each of our market segments. We believe this
is necessary so that we can be viewed by our customers not as a system
infrastructure provider, but rather as a total solution provider.
* LEVERAGE OUR CORE TECHNOLOGY ACROSS MARKET SEGMENTS. We will pursue
new markets and applications for our systems, products and
technologies.
* NURTURE KEY BUSINESS PARTNERS AND STRATEGIC ALLIANCES. We will nurture
our existing business relationships, and develop new ones with
partners who have strong national and international presences. We will
use these business relationships to further penetrate our targeted
markets.
* DEVELOP OUR NEWLY CREATED DIVISIONS AND PENETRATE FURTHER THE MARKETS
THEY SERVE. We will continue to invest in our newly created divisions
and staff them with the skilled professionals
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necessary to effectively and efficiently maximize order generation for
our systems, products and services in the markets they serve.
* INVEST IN OUR CORE COMPETENCIES. We will continue to attract and
retain highly skilled professionals in these critical disciplines:
industry specific marketing and sales; multimedia content development,
acquisition and management; systems and software engineering; supplier
management; finance; contracts administration; and program management
applied to large-scale systems.
PRODUCTS AND SERVICES
TECHNOLOGY
The hardware for our interactive systems consists of high speed Cheetah
servers, multiple disk drives, networking infrastructure, set-top personal
computers, and televisions or other electronic displays that serve as monitors
for our systems. Our TransPORTAL system software is based on standardized Web
browser component technology. Our systems provide a variety of informative,
entertainment and interactive content which may be accessed and viewed on
demand. Our systems are 100% digital and offer our customers flexibility in
adding new content to the system, as well as the ability to customize and brand
their marketing vision via the "look and feel" of the underlying graphical user
interface.
Dual, fault-tolerant Cheetah servers serve as the heart of our systems. One
Cheetah server operates as the local area network backbone and can provide up to
100 megabit connectivity to each user on the system. The scaleable architecture
of our server is based on Intel processors and Microsoft operating systems. Our
systems interface with a variety of color flat panel computer monitors and
television displays.
The design for our interactive information and entertainment systems are
proprietary to us, as are our Cheetah video servers and TransPORTAL software
tools. However, other hardware and components used in our systems are
predominantly commercial, off-the-shelf hardware, based on non-proprietary or
open-system computer and IP network standards. We believe that this use of
available commercial hardware allows us to outsource component product
manufacturing to suppliers without compromising overall product quality and
reliability. We believe that it also allows us to focus our operations resources
on supplier management, final assembly and testing.
Each of our video servers can scale to serve up to 300 simultaneous users.
We can install multiple video servers where required.
TURNKEY INTERACTIVE INFORMATION AND ENTERTAINMENT SYSTEMS
We currently market three customized turnkey systems. Each of these systems
is built on our Cheetah servers and TransPORTAL software package. We customize
the content available through our systems to provide the best total solution for
our respective market purchasers:
* TrainView is our newest system solution. We anticipate that our
TrainView system will provide interactive entertainment and other
content to be determined in conjunction with future customers, if any.
We have developed a TrainView prototype, which we are currently
marketing to train operators in Europe and Asia.
* InnView is our system solution for the hotel and time-share market.
Generally, we expect to provide interactive and entertainment content
for use by the hotel guests. The system is also designed to provide
Internet access over the television, voice over IP, and concierge and
other guest services. Some of the content can be available free of
charge, some can be advertising supported, and some can be available
on a pay-per-use basis. We will share revenues from advertising and
pay-per-use with the hotels on a negotiated percentage basis.
* CruiseView is our system solution for the cruise ship market. The
system is designed to provide information, entertainment, gaming,
shore excursions and free-to-guest services. The system is also
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designed to provide Internet access over the television, voice over
IP, and concierge and other guest services. Some of the content can be
available free of charge, some can be advertising supported, and some
can be available on a pay-per-use basis. We will share revenues from
advertising and pay-per-use with the cruise lines on a negotiated
percentage basis.
SERVER SALES
Our current business strategy is to offer and sell complete, turnkey
interactive information and entertainment systems. However, a substantial
portion of our revenues generated since June 30, 1999 have come from the sale of
our Cheetah video servers which have been part of a system designed and
installed by others. Although we will continue to offer and sell the servers as
stand-alone, high-end, video servers, we are endeavoring to be known as a total
system solution provider in the education market as well as in the other markets
we serve.
CONTENT
We obtain the content which we show on our systems in several different
ways. Movies are obtained by licensing products from industry suppliers. Other
content is purchased or licensed from other providers.
We expect to expand all of our systems to include additional content and
features, such as Internet access, on-line shopping and local entertainment
guides. We are currently developing our content division which will oversee this
development. Our content division is also looking to provide a total solution
system for the education and corporate training markets.
OUR HISTORY
We were incorporated in Georgia in 1986. Our common stock is listed on the
Nasdaq SmallCap Market under the ticker symbol "TNCX." Our primary focus under
prior management from inception to 1995 was providing video products and
services to the educational market. After an initial public offering in 1995,
prior management began to market interactive information and entertainment
systems to the commercial airline and passenger cruise ship industries.
Our AirView product was installed on two Fairlines Airlines aircraft. In
addition, the in-flight entertainment system developed by the Interactive
Entertainment Division we acquired from Global Technologies was installed on 19
Swissair aircraft, two Debonair Airlines aircraft and three Alitalia aircraft.
The heavily regulated nature of the airline market prohibitively increased our
costs. Fairlines filed for bankruptcy protection and we were never able to
collect the amounts owed to us. These facts, together with the Swissair
litigation, led us and Global Technologies to stop pursuing this market in 1998.
See "Risk Factors - We are a defendant in a multi-district, mass tort class
action lawsuit."
In addition, prior management entered into agreements with Carnival Cruise
Lines and Star Cruises to install our systems on several of their cruise ships.
Operational problems on the Star cruise ship led Star to cancel its agreement,
and we were unable to recover our investment. Prior management also negotiated a
fixed price agreement with Carnival Cruise Lines and installed a system on one
Carnival ship. We have terminated the Carnival agreement, through a mutual
release which allows us to retain our equipment and recognize revenue of $1.4
million for the sale of networking equipment aboard the ships. We continue to
operate our CruiseView(TM) system on one 1,040-cabin Carnival ship while we
negotiate the terms of a potential forward-looking agreement to deploy our
latest CruiseView(TM) solution.
Early in 1999, prior management's inability to collect receivables and
other administrative problems left us struggling financially and in need of
capital. In May 1999, Global Technologies, Ltd., a Delaware corporation listed
on the Nasdaq National Market under the ticker symbol "GTLL," acquired majority
control of us by exchanging the assets of its Interactive Entertainment Division
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and approximately $4.25 million in cash for 1,055,745 shares of our common stock
and 2,945,400 shares of our Series D Convertible Preferred Stock. This
transaction gave Global Technologies ownership of approximately 60% of our then
outstanding common equity on a fully diluted basis. Through a series of
additional transactions, Global Technologies acquired additional shares of our
common stock and shares of our Series B Convertible Preferred Stock so that, on
a fully converted basis, it now owns approximately 79% of our outstanding common
equity. The transaction brought together synergistic technologies, and the
engineering and program management capabilities of two companies experienced in
the field of developing, manufacturing, marketing and installing interactive
information and entertainment systems.
In connection with the acquisition, Global Technologies elected a new board
of directors, which put in place our current management team. The board of
directors was re-elected, with the exception that Robert Pringle was elected to
take the place of Morris Aaron, at the 2000 annual meeting of shareholders on
May 11, 2000.
OUR DIVISIONS AND MARKETS
Under new management, we have identified four primary markets for our
products and services. We believe these markets represent opportunities to
achieve substantial market share and profitability. These markets are: (1)
hotels and time-share properties, (2) cruise ships, (3) educational institutions
and corporate training, and (4) long-haul passenger trains. In an effort to
capitalize on opportunities in these markets, we have formed separate sales and
marketing divisions, and have recently hired experienced executives to lead each
of the four divisions.
HOTELS AND TIME-SHARE PROPERTIES
We have begun to market our products and services to "land-based" hotels
and time-share properties in North America. In addition, we are in the process
of developing sales and marketing strategies for hotels and time-share
properties in Europe, Asia and South America. We call the system we market to
the hotel and time-share market "InnView." Initially, we are focusing our
efforts on hotels with 100 or more rooms.
We formed our Hotel & Hospitality Division in December 1999. Management
believes there are approximately 3.6 million rooms in the domestic hotel market,
approximately 1.9 million of which do not have in-room information and
entertainment systems. Management also believes there are almost 0.5 million
time-share properties which also do not have installed information and
entertainment systems. Of the unserved hotel rooms, we estimate that
approximately 0.8 million would meet the economic criteria for installation of
our InnView systems. In addition, we estimate that contracts covering
approximately 1.7 million domestic hotel rooms currently served by a
competitor's system will come up for renewal over the next five years.
Since forming this division, we have retained several national and
international sales executives. To date, we have entered into agreements for our
InnView system for over 2,800 guest rooms, and have live, operational
installations in over 800 rooms.
Generally, we expect our InnView systems to become operational within four
months after entering into an agreement with a particular hotel. We have not
installed InnView in any time-share properties. We provide the systems at no
cost to the hotel in exchange for a revenue share agreement in which we retain
the majority of such revenues or we share in the up-front installation costs and
share the revenues on a commensurate basis.
PASSENGER RAIL
There are currently 11 operators of long-haul passenger trains in the
world. We believe that each of these operators are potential customers for our
TrainView system over the next several years. The fleets operated by these
companies contain an aggregate of almost one million seats that could be fitted
with our TrainView systems. However, to date, no trains have been fitted with
information or entertainment systems.
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In September 1999, we formed a Passenger Rail Division to promote our
interactive information and entertainment systems for installation at individual
seats on long-haul and cross-country passenger trains in the U.S., European and
Asian markets. This system is called "TrainView." We announced the appointment
of Stephen J. Ollier, the former General Manager of ALSTOM Railway Maintenance
Services, Ltd., as President of the division. We believe that Mr. Ollier is
uniquely qualified for the position, offering both the technical and industry
experience we believe necessary to bring TrainView to the international rail
market.
In May 1999, ALSTOM Transport Ltd., a unit of ALSTOM SA, which is one of
the largest train manufacturers in the world, contracted with us to engineer
TrainView into ALSTOM's high-speed train design. We were paid in connection with
the contract but expect no further business from ALSTOM because we have become
aware that ALSTOM is in the process of creating a subsidiary to compete with us
in the passenger rail market.
Under the direction of Mr. Ollier, we have submitted pricing proposals to
two train operators in the United Kingdom for installation of TrainView systems.
To date, we have not installed TrainView on any passenger train.
CRUISE SHIPS
Management estimates that there are currently more than 70 cruise ships in
revenue service with 500 or more guest cabins. We estimate that the current
construction schedules for ships of this size show more than 30 new ships
entering service between now and the end of 2004. In total, we estimate the
market to host over 10 million passenger cruises annually, the vast majority of
which are hosted by one of a handful of leading cruise operators. We believe
that only about ten ships to date have had interactive entertainment and
information systems installed.
Historically, the cruise line industry has not embraced the installation of
interactive systems in individual cabins like their hotel counterparts. The
major reason for this reluctance is not related to a lack of demand. Only
recently has the technology of interactive guest systems progressed to levels
that enable them to profitably and logistically contribute to cruise line
profits and the vacation experience. In fact, the most significant hurdles have
been adapting the system to the compact configuration and harsh environment of
cruise ships, while maintaining adequate levels of price and performance.
We have had over a year's experience with our systems aboard Carnival
Cruise Lines, and have recently developed an enhanced version of our CruiseView
technology platform, increasing its performance and capabilities. We are in
advanced discussions with several major cruise companies about installing this
interactive system, including Carnival.
EDUCATION AND CORPORATE TRAINING
We continue to manufacture our Cheetah family of multimedia servers for the
interactive education and corporate training markets. Sales of servers have
historically been a core business of ours, with over 2,000 Cheetah video servers
sold worldwide.
In August 1999, we sold multimedia servers in connection with the first
phase of the Georgia school system's Net 2000 project. We supplied our Cheetah
video servers as the central backbone of 193 Georgia schools' multimedia
networks. Two other Cheetah servers were delivered in connection with the order
and installed at the Georgia schools' network operating center. Using our
servers, students and teachers are able to access, on-demand, hundreds of hours
of digitally stored multimedia content, access the Internet and build
interactive courses. The total value of orders received under the program to
date is $5.4 million. We believe that this installation is the largest of its
kind in the country and that it may well be a model for the expansion of this
type of program. Our sales to MRESA were limited to our Cheetah video servers.
In the future, we hope to be able to sell entire interactive systems, which we
call "EduView," to school related purchasers.
In 1999, the Federal government instituted the E-Rate Program, which has a
primary goal of bringing the Internet and various forms of multimedia content
directly to elementary and secondary classrooms. The program makes $2.25 billion
available to schools to obtain the technology necessary to achieve this goal. To
obtain these funds, a school district must make application and pay a portion of
the equipment cost. A significant amount of the funding for our delivery of 195
Cheetah video servers to Georgia schools in connection with the Georgia MRESA
Net 2000 project came from the E-Rate Program.
We formed our Education & Corporate Training Division in December 1999 to
promote our interactive products and services to educational institutions and
corporate training departments. In addition, we hired James D. Oots and Farley
Barge as leaders of this division. This team brings to us a great deal of
experience in the corporate training and education markets.
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ACQUISITION, PACKAGING AND MONITORING OF BROADBAND, MULTIMEDIA CONTENT
In an effort to capitalize on what we believe to be the advantages of our
system architecture and technology, we are developing a division to acquire,
package and monitor a broad range of compelling multimedia content tailored to
appeal to the typical end-users in each of our market segments. We believe that
the provision of compelling content through our systems will encourage user
interaction with the system, which, in turn, should maximize pay-for-use revenue
generation for us and for our vertical market partners.
We believe that our content division will be integral to our success. The
revenue generated from content can be long-term and should span the life-cycle
of our systems. In addition, because it is generally industry practice in the
markets we serve to share the cost of system hardware, and in the hotel market
to provide the hardware free of charge, content revenue will be an essential
revenue source.
OUR SALES, MARKETING AND DISTRIBUTION
We currently market our systems, products and services worldwide through
the efforts of our sales people in each operating division. We also plan to
market our systems through value-added resellers, distributors and alliance
partners. System installation and on-site customer support are provided through
internal customer engineering personnel and may, in the future, be provided
through the efforts of value-added resellers and alliance partners.
The sales arrangements for our systems depends upon various factors, such
as the size and type of hotel, time-share property, ship or train, and the
system features and other requested customization. There is generally a long
sales-cycle for our systems because of the need to design the system
configuration for the particular environment in which the system will be
installed, test each installed system and to negotiate any necessary agreements
with other providers. The sales cycle is also dependent upon a number of factors
beyond our control, such as the financial condition of the customer, safety and
maintenance concerns, regulatory issues, and purchasing patterns of particular
operators and the industry generally. This is expected to result in long and
unpredictable buying patterns for our systems.
OUR COMPETITION
We face substantial competition in each of our markets. Some general
factors that we believe will influence whether we succeed include:
* the ability to deliver total system solutions for our customers,
including, in particular, content acquisition and management;
* system quality, reliability and performance;
* product hardware and software that can easily be upgraded during the
product life cycle;
* market-driven pricing of our systems, products and services, and
* the ability to deliver new sources of revenue generation for our
customers.
There are three major providers of interactive guest services systems in
the hotel and hospitality market. On Command Corporation (NASDAQ:ONCO) has the
greatest market share with approximately one million rooms, followed by LodgeNet
Entertainment Corporation (NASDAQ:LNET) with approximately 780,000 rooms, and
Quadriga. On Command and LodgeNet focus their sales and marketing efforts on
North American properties, whereas Quadriga markets its products primarily to
European hotels and to a much lesser extent Middle Eastern and African hotels.
All of these competitors employ a technology that is different from ours. We
believe our systems designs are superior to those of our competitors because the
scalability of our servers permits us to provide the content at each site such
that all selections are always available. By contrast, our competitors are
sometimes required to omit movie titles which are temporarily unavailable
because the number of copies of those titles at the site are all in use. In
addition, we believe that our system designs are superior based on the content
and features offered, such as Internet connectivity and voice-over IP that can
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be made available through the systems. Our two primary competitors in the cruise
ship market are Allin Interactive (NASDAQ:ALLN) and Siemens. We estimate that
Allin currently has two installed systems on two cruise ships with Royal
Caribbean, while Siemens has a system installed on one.
Although we have an opportunity to be first-to-market in providing train
operators with interactive multimedia information and entertainment system
solutions, SmartWorld, a UK-based company, has announced its intention to
develop and offer a limited video-on-demand system for the passenger rail
market. Matsushita, a leading provider of in-flight entertainment systems in the
long-haul commercial airplane market, is considering an entry into this market.
In addition, we are aware that ALSTOM and Adtranz are creating subsidiaries in
an effort to compete in this market.
Our Cheetah video servers apply hardware control of video streaming to
achieve high-integrity, MPEG-2 quality images and pause, fast-forward, and
rewind capabilities. These servers are scaleable to provide up to 300
simultaneous video streams. Competitor video server products in this market,
such as are provided by Dell, Gateway, Silicon Graphics, Compaq and Hewlett
Packard, are high-speed, general-purpose servers, with software control of
limited video streams (typically less than 10 to 15). nCube has high end video
servers which may also compete with us.
All of these companies have greater financial, technical and marketing
resources than we do. Moreover, our competitors have developed goodwill and name
recognition among the hospitality operators whom we call on to solicit sales,
and also among end users who have grown accustomed to their offerings. In
addition, we expect that to the extent that the market for our systems, services
and products develops, competition will intensify and new competitors will enter
our designated target markets. We may not be able to compete successfully
against existing and new competitors as the market for our systems, products and
services evolves and the level of competition increases. A failure to compete
successfully against existing and new competitors would have a materially
adverse effect on our business and results of operations.
OUR OPERATIONS AND MANUFACTURING
Contract manufacturers assemble our proprietary systems in the United
States. Final assembly, integration, burn-in and functional testing are
conducted at our facilities in Phoenix, Arizona or at supplier or customer
locations.
We obtain electronic components and finished sub-assemblies for our system
components "off-the-shelf" from a number of qualified suppliers. We have
established a testing protocol in an effort to ensure that components and
sub-assemblies meet our specifications and standards before final assembly and
integration. We have elected to procure off-the-shelf component parts and
sub-assemblies from suppliers in an effort to ensure better quality control and
pricing. To date, we have experienced some interruptions in the supply of
component parts and sub-assemblies due to the lack of availability of certain
electronic components, and are identifying additional qualified suppliers. The
inability of our current suppliers to provide component parts to us, coupled
with our inability to find alternative sources, would adversely affect our
operations.
RESEARCH AND DEVELOPMENT
The market for our systems and products is characterized by rapid
technological change and evolving industry standards, and it is highly
competitive with respect to timely product innovation. The introduction of
products embodying new technology and the emergence of new industry standards
can render existing products obsolete and unmarketable. We believe that our
future success will depend upon our ability to develop, manufacture and market
new systems and products, as well as enhancements to existing systems and
products on a cost-effective and timely basis. The system architecture for our
interactive information and entertainment systems has been designed to permit
hardware and software upgrades over time. Moreover, we believe that the current
architecture presents no known limits on a customer's ability to offer
compelling content to the user in a rapid and reliable manner. Therefore, a
major focus of our research and development efforts is to reduce the cost of
network and client hardware and to enhance the core software of the system to
permit even easier integration of new content.
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If we are unable, for technological or other reasons, to develop new
systems and products in a timely manner in response to changes in the industry,
or if systems and products or system and product enhancements that we develop do
not achieve market acceptance, our business will be materially adversely
affected. There can be no assurance that technical or other difficulties in the
future will not delay the introduction of new systems, products or enhancements.
PROTECTING OUR INTELLECTUAL PROPERTY
We rely on a combination of trade secret and other intellectual property
law, nondisclosure agreements with most of our employees and other protective
measures to establish and protect our proprietary rights in our systems and
products. We believe that because of the rapid pace of technological change in
the open systems networking industry, legal protection of our proprietary
information is less significant to our competitive position than factors such as
our strategy, the knowledge, ability and experience of our personnel, new system
and product development and enhancement, market recognition and ongoing product
maintenance and support. Without legal protection, however, it may be possible
for third parties to copy aspects of our systems and products or technology, or
to obtain and use information that we regard as proprietary. In addition, the
laws of some foreign countries do not protect proprietary rights in products and
technology to the same extent as do the laws of the United States. Although we
continue to implement protective measures and intend to defend our proprietary
rights vigorously, we give no assurance that these efforts will be successful.
Our failure or inability to effectively protect our proprietary rights could
have an adverse affect on our business.
EMPLOYEES
We employ 77 full-time staff at our various locations and sales offices and
we are adding skilled personnel in the following fields: content procurement and
development; software, systems and hardware engineering; program management;
contracts administration; supplier management; customer engineering; and sales
and marketing.
We have formed separate vertical sales and marketing divisions for each of
our four target markets. These divisions are anchored by the recent hiring of
experienced executives from within each of these markets. We anticipate that
these executives will be able to leverage our core technology in broadband,
multimedia content distribution and IP network solutions to increase sales of
our systems, products and services. We have recognized the need to create an
additional internal operating division to provide our customers with the
personalized programming necessary to bring users a broad range of content
options. We are in the process of hiring personnel to anchor this new division.
WARRANTIES
The Company provides a warranty regarding its products for periods ranging
from one to three years, depending on the requirements of customers. To date,
the Company has not experienced significant claims under warranties, and its
ability to meet the full demands of having a significant number of units sold to
customers who require such service has not been tested. The Company also passes
through to end users the warranties that it receives from vendors on any
separate hardware, software or component parts that it sells independently of
full systems.
ITEM 2 - DESCRIPTION OF PROPERTY
We lease the following facilities, which we believe are adequate and
suitable for current operations:
* approximately 3,500 square feet of office space located at 1811
Chestnut Street, Philadelphia, Pennsylvania used for executive and
administrative purposes;
* approximately 17,000 square feet of office and production space
located at 222 North 44th Street, Phoenix, Arizona;
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* approximately 16,000 square feet of office space in Conshohocken,
Pennsylvania to be used for administrative purposes and our content
operations; and
* approximately 1,000 square feet of space in Derby, England where our
Passenger Rail Division is headquartered.
ITEM 3 - LEGAL PROCEEDINGS
Swissair/MDL-1269, IN REGARDS TO AN AIR CRASH NEAR PEGGY'S COVE, NOVA
SCOTIA. This multi-district litigation, which is being overseen by the United
States District Court for the Eastern Division of Pennsylvania, relates to the
crash of Swissair Flight No. 111 on September 2, 1998. The Swissair MD-11
aircraft involved in the crash was equipped with an entertainment network system
that had been sold to Swissair by Global's predecessor company, Interactive
Flight Technologies, Inc. Estates of the victims of the crash have filed
lawsuits throughout the United States against Swissair, Boeing, Dupont and
various other parties, including Global and TNCi, which has been named in some
of the lawsuits filed on a successor liability theory. TNCi and Global deny all
liability for the crash. TNCi and Global are being defended by our aviation
insurer.
On September 1, 1999, SAir Group invited the Company to participate in a
conciliation hearing before the Justice of the Peace in Kloten, Switzerland,
which is the customary manner in which civil litigation is initiated in
Switzerland. The document informing us of the proceeding states that the request
has been filed in connection with the crash of Swissair Flight 111 primarily in
order to avoid the expiration of any applicable statutes of limitations and to
reserve the right to pursue further claims. The document states that the relief
sought is "possibly the equivalent of CHF 342,000,000 - in a currency to be
designated by the court; each plus 5% interest with effect from September 3,
1998; legal costs and a participation to the legal fees (of the plaintiff) to be
paid by the defendant."
BRYAN R. CARR V. THE NETWORK CONNECTION, INC. AND GLOBAL TECHNOLOGIES,
LTD., Superior Court of Georgia, Civil Action No. 99-CV-1307. Bryan R. Carr,
TNCi's former Chief Operating and Financial Officer and a former Director, filed
a claim on November 24, 1999 alleging a breach of his employment agreement with
TNCi. Mr. Carr claims that he is entitled to the present value of his base
salary through October 31, 2001, a share of any "bonus pool," the value of his
stock options and accrued vacation time. TNCi and Global filed a motion to
compel arbitration of the claims pursuant to an arbitration provision in the
employment agreement and to stay the State Court action pending the arbitration
proceeding. The Company's motion was granted on August 9, 2000. As of this date,
Mr. Carr has not filed an arbitration claim against TNCi or Global, but on
September 20, 2000, Mr. Carr sent a letter to the Company stating his demands in
hopes of settlement.
A suit captioned LODGENET ENTERTAINMENT CORPORATION V. THE NETWORK
CONNECTION, INC. was filed April 5, 2000 in the Circuit Court for the Second
Judicial Circuit of the State of South Dakota. The action arose out of TNCi's
hiring of Theodore P. Racz, a former LodgeNet Entertainment Corporation
employee, as its Senior Vice President of the Hotels & Hospitality division.
LodgeNet alleged tortious interference with contract and tortious interference
with business relationships. LodgeNet sought to prohibit Mr. Racz from being
employed by TNCi, as well as damages, and fees and costs. This case was
voluntarily dismissed without prejudice by LodgeNet because there was no
jurisdiction in South Dakota.
A suit captioned AVNET, INC. V. THE NETWORK CONNECTION, INC., was filed May
17, 2000 in Maricopa County Superior Court, CV2000-009416. The suit relates to
invoices for inventory purchased by TNCi in late 1998 and early 1999. Avnet,
Inc. seeks payment of the invoices, interest and legal fees. TNCi has not paid
for the inventory purchased primarily for the following reasons: (i) the
inventory purchased did not meet specifications and thus was not accepted by
TNCi's customer, and (ii) TNCi is currently pursuing a separate warranty claim
against Avnet regarding certain other inventory purchased from Avnet.
The Company is subject to other lawsuits and claims arising in the ordinary
course of its business. In the Company's opinion, as of June 30, 2000, the
effect of such matters will not have a material adverse effect on the Company's
results of operations and financial position.
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ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On May 11, 2000 at an Annual Meeting of Shareholders, the following matters
were submitted to a vote of security holders:
1. To elect four (4) directors to hold office as follows: M. Moshe Porat
and Stephen Schachman to hold office until the 2001 Annual Meeting; Robert
Pringle to hold office until the 2002 Annual Meeting; and Irwin L. Gross to hold
office until 2003 Annual Meeting; and
2. To ratify the selection of KPMG LLP as auditors of the Company for the
fiscal year ending June 30, 2000.
VOTES ABSTENTION AND
AGAINST OR BROKER
MATTER VOTES FOR WITHHELD NON-VOTES
------ --------- -------- ---------
Proposal #1
- M. Moshe Porat 11,365,642 7,700 0
- Stephen Schachman 11,365,642 7,700 0
- Robert Pringle 11,365,642 7,700 0
- Irwin L. Gross 11,365,642 7,700 0
Proposal #2 11,365,642 7,700 600
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PART II
ITEM 5 - MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is listed on The NASDAQ SmallCap Market. The
following table shows the high and low bid prices in dollars per share for the
last two years as reported by NASDAQ.
YEAR ENDED JUNE 30, 1999 LOW HIGH
------------------------ --- ----
First Quarter $ 1.813 $ 4.938
Second Quarter $ 2.000 $ 4.125
Third Quarter $ 2.125 $ 3.938
Fourth Quarter $ 1.375 $ 3.375
YEAR ENDED JUNE 30, 2000 LOW HIGH
------------------------ --- ----
First Quarter $ 1.250 $ 2.906
Second Quarter $ 1.438 $ 7.000
Third Quarter $ 5.375 $ 13.375
Fourth Quarter $ 2.875 $ 8.719
As of September 25, 2000, there were approximately 100 record holders of
the Company's Common Stock, but the Company believes that there are
approximately 2,200 beneficial shareholders, based upon broker requests for
distribution.
DIVIDEND POLICY
Holders of the Company's Common Stock are entitled to receive dividends
only when declared by the Company's Board of Directors. Other than prior to
September 22, 1994 when the Company made distributions to shareholders as an S
corporation, dividends have never been declared or paid and the Company does not
plan to make any dividend payments in the foreseeable future. Instead the
Company will reinvest in the expansion and development of our business. If the
Board of Directors decides to declare a dividend in the future, the decision
will be based on our earnings, financial condition, cash requirements, and any
other factors they deem relevant.
ITEM 6 - MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
THE FOLLOWING DISCUSSION OF OUR FINANCIAL CONDITION AND RESULTS OF
OPERATIONS SHOULD BE READ TOGETHER WITH THE CONSOLIDATED FINANCIAL STATEMENTS
AND THE RELATED NOTES INCLUDED IN ANOTHER PART OF THIS ANNUAL REPORT AND WHICH
ARE DEEMED TO BE INCORPORATED INTO THIS SECTION. THIS DISCUSSION CONTAINS
FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. OUR ACTUAL
RESULTS MAY DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THOSE FORWARD-LOOKING
STATEMENTS AS A RESULT OF CERTAIN FACTORS, INCLUDING BUT NOT LIMITED TO, THOSE
SET FORTH UNDER AND INCLUDED IN OTHER PORTIONS OF THIS ANNUAL REPORT. SEE
"FORWARD-LOOKING STATEMENTS" ON PAGE 22.
BACKGROUND AND BASIS OF PRESENTATION
We design, manufacture, install and maintain advanced, high-performance
computer servers and interactive, broad-band information and entertainment
systems. We also procure and provide the content available through the systems.
These all-digital systems deliver an on-demand, multimedia experience via
high-speed, high-performance Internet Protocol (IP) networks. These systems are
designed to provide users access to information, entertainment and a wide array
of service options, such as shopping for goods and services, computer games,
access to the World Wide Web and on-line gambling, where permitted by applicable
law. The targeted markets for our products are hotels and time-share properties,
cruise ships, educational institutions and corporate training, and passenger
trains.
On May 18, 1999, we obtained substantially all of the assets and certain
liabilities of the Interactive Entertainment Division of Global Technologies,
Ltd. (formerly known as Interactive Flight Technologies, Inc.) and $4,250,000 in
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cash in exchange for 1,055,745 shares of our common stock and 2,495,400 shares
of our Series D Convertible Preferred Stock. For accounting purposes, this
acquisition is treated as a reverse merger. Global Technologies is deemed to
have acquired us. As a result, we are treated as the successor to the historical
operations of the Interactive Entertainment Division and our financial
statements, which have been reported to the SEC on Forms 10-KSB and 10-QSB,
among others, have been replaced with those of the Interactive Entertainment
Division. We will continue to file as a SEC registrant and continue to report
under the name The Network Connection, Inc.
We changed our fiscal year-end from December 31 to June 30. Accordingly,
the eight-month period resulting from this change - November 1, 1999 through
June 30, 1999 - is referred to in this report as the "transition period."
For accounting purposes, the date of the acquisition of the Interactive
Entertainment Division was May 1, 1999. The financial statements as of and for
the year ended October 31, 1998 reflect the historical results of the
Interactive Entertainment Division as previously included in Global
Technologies' consolidated financial statements. Included in the financial
statements for the eight months ended June 30, 1999 are the historical results
of the Interactive Entertainment Division through April 30, 1999, and the
results of the post-transaction company for the two months ended June 30, 1999.
All consolidated financial statements from July 1, 1999 forward reflect the
results of the post-transaction company.
As of June 30, 2000, we were a 79% owned subsidiary of Global Technologies,
whose ownership was represented by 1,500 shares of our Series B 8% Convertible
Preferred Stock, 2.5 million shares of our Series D Preferred Stock and
approximately 8.1 million shares of our common stock. In addition, pursuant to
the terms of the acquisition of Global Technologies' Interactive Entertainment
Division, Global Technologies is entitled to receive 270,081 additional shares
of the Company's Common Stock on account of claims that arose during the
one-year period following the acquisition.
Our consolidated financial statements are prepared using generally accepted
accounting principles applicable to a going concern which contemplate the
realization of assets and liquidation of liabilities in the normal course of
business. We have incurred net losses from operations for two of the last three
periods, had an accumulated deficit at June 30, 2000 as a result of efforts to
build our customer base and develop our operations. Management believes that our
current cash balances, the $5 million credit facility with Global Technologies
(of which approximately $2.7 million remained available as of September 29,
2000), and currently available external sources of financing will not be
sufficient to meet our currently anticipated cash requirements for operations
for the next 12 months. A substantial portion of our accounts payable are past
due and many suppliers have imposed cash on delivery terms. We are in
discussions with private equity sources which, if transactions are consumated,
together with the Global Technologies credit facility and currently available
external sources of financing, should provide sufficient short-term funding. Our
inability to draw on the credit facility with Global Technologies, to obtain
funds pursuant to the currently available external sources of financing, or not
complete certain private placement transactions, would have a material adverse
effect on our operating results, financial condition and ability to continue as
a going concern.
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Global Technologies does not currently have sufficient cash for us to
borrow under the credit facility and no assurance can be given that currently
available external sources of financing will have the resources necessary to
meet its commitments as we draw down from time to time pursuant to our private
equity line, or that any other financings will be consumated. Additionally, any
increase in our growth rate, shortfalls in anticipated revenues, increase in
anticipated expenses, or significant acquisition or expansion opportunities
could have a material adverse effect on our liquidity and capital resources and
would require us to raise additional capital from public or private equity or
debt sources in order to finance operating losses, anticipated growth, and
contemplated capital expenditures and expansions.
We have significant expansion plans which we intend to fund with the
facilities discussed above; however, if there is any delay in consumating these
facilities, we will not engage in such expansion until adequate capital sources
have been arranged. If such sources of financing are insufficient or
unavailable, we will be required to modify our growth and operating plans or
scale back operations to the extent of unanticipated opportunities, such as
acquisitions of complementary businesses or the development of new products, or
otherwise respond to unanticipated competitive pressures. There can be no
assurance that we will be able to raise any such capital on terms acceptable to
us or at all.
We expect to continue to focus on developing and expanding our enhanced
broadband information and entertainment systems while continuing to expand our
current operation's market penetration. Accordingly, we expect that our capital
expenditures and cost of revenues and depreciation and amortization expenses
will continue to increase significantly, all of which could have a negative
impact on short-term operating results. In addition, we may change our strategy
to respond to a changing competitive environment. There can be no assurance that
growth in our revenue or market penetration will continue, that our expansion
efforts will be profitable, or that we will be able to achieve or sustain
profitability or positive cash flow. Further, we will require substantial
financing to continue as a going concern, accomplish any significant acquisition
or merger transaction, and provide for working capital to operate our current
and proposed expanded operations until profitability is achieved, if ever.
RESULTS OF OPERATIONS
In August 1999, our fiscal year-end was changed from December 31 to June
30. Our financial statements included in this Annual Report on Form 10-KSB
contain the results from operations for our fiscal year ended October 31, 1998,
for the eight-month Transition Period ended June 30, 1999 and for our fiscal
year ended June 30, 2000. For purposes of this management's discussion and
analysis, for comparative purposes only, we will refer to the pro forma
unaudited results of operations for the twelve-month period ended June 30, 1999.
In some instances, where we compare results for the pro forma unaudited twelve
months ended June 30, 1999 with the fiscal year ended October 31, 1998, please
note that there is a four-month overlap between such periods. The pro forma
unaudited results of operations for the twelve months ended June 30, 1999 and
audited year ended June 30, 2000 are as follows:
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TWELVE MONTHS
YEAR ENDED ENDED
JUNE 30, 2000 JUNE 30, 1999
(AUDITED) (PRO FORMA UNAUDITED)
------------ ---------------------
Revenues:
Equipment sales $ 6,983,787 $ 980,533
Service income 107,873 411,677
------------ -----------
Total revenues 7,091,660 1,392,210
Cost of equipment sales 4,867,519 1,801,037
Cost of service income 61,978 736
General and administrative expenses 9,827,804 9,881,556
Reversal of warranty, maintenance and
commission accruals -- (7,151,393)
Provision for doubtful accounts -- 28,648
Non-cash compensation expense 1,005,232 --
Special charges 2,156,205 331,590
Amortization of intangibles 912,553 74,981
------------ -----------
Total operating expense 18,831,291 4,967,155
------------ -----------
Operating loss (11,739,631) (3,574,945)
Other income (expense):
Interest expense (4,602,183) (86,373)
Interest income 109,001 154,629
Other expense (19,386) (567,307)
Cumulative dividend on preferred stock (120,000) (30,667)
------------ -----------
Net loss available to common shareholders $(16,372,199) $(4,104,663)
============ ===========
REVENUES
Revenue for the year ended June 30, 2000 was $7,091,660, an increase of
$5,699,450 (or 409%) compared to revenue of $1,392,210 (unaudited) for the
twelve months ended June 30, 1999. Equipment sales of $6,983,787 for the year
ended June 30, 2000 are comprised principally of approximately $5.4 million
generated from the sale of 195 of the Company's Cheetah(R) video servers in
connection with the Georgia Metropolitan Regional Education Services Agency
("MRESA") Net 2000 project and approximately $1.4 million related to network
equipment installed onboard two Carnival ships. (See Liquidity and Capital
Resources for a discussion of Carnival Settlement Agreement.) Service income of
$107,873 for the year ended June 30, 2000 is comprised principally of $48,046
provided by the Company's share of revenue generated by the Cruise View system
on two Carnival ships and $59,827 generated from design services provided to
ALSTOM Transport Ltd. ("Alstom"). The Company provided these services to Alstom,
but expects no further business from Alstom as they plan to create a subsidiary
that would compete with the Company in the passenger rail market. Equipment
sales of $980,533 (unaudited) for the twelve months ended June 30, 1999 are
comprised principally of $875,957 (unaudited) generated from payments received
from Swissair for one of four entertainment networks billed per the April 1998
contract with Swissair and $89,028 (unaudited) generated from the sale of spare
parts needed for the entertainment networks installed previously on three
Swissair aircraft. Service income of $411,677 (unaudited) for the twelve months
ended June 30, 1999 was principally generated from programming services provided
to Swissair, representing the Company's share of gaming profits generated by the
Swissair systems and revenue earned under the Swissair extended warranty
contract. There will be no further revenue under the Swissair agreement.
Revenue for the twelve months ended June 30, 1999 was $1,392,210, a
decrease of $17,424,752 (or 93%) compared to revenue of $18,816,962 for the year
ended October 31, 1998. Equipment sales of $980,533 (unaudited) for the twelve
months ended June 30, 1999 are comprised principally of $875,957 (unaudited)
generated from payments received from Swissair for one of four entertainment
networks billed per the April 1998 contract with Swissair and $89,028
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(unaudited) generated from the sale of spare parts needed for the entertainment
networks installed previously on three Swissair aircraft. Service income of
$411,677 (unaudited) for the twelve months ended June 30, 1999 was principally
generated from programming services provided to Swissair, representing the
Company's share of gaming profits generated by the Swissair systems and revenue
earned under the Swissair extended warranty contract. Equipment sales of
$18,038,619 for the year ended October 31, 1998 was generated as a result of
installations completed by the Company under the initial Swissair program on ten
business class and eighteen first class planes. Service income of $778,343 for
the year ended October 31, 1998 was principally generated from programming
services provided to Swissair, the Company's share of gaming profits generated
by the Swissair systems and revenue earned under the Swissair extended warranty
Letter of Intent.
COST OF SALES
Cost of equipment sales for the year ended June 30, 2000 were $4,867,519,
an increase of $3,066,482 (or 170%) compared to cost of equipment sales of
$1,801,037 (unaudited) for the twelve months ended June 30, 1999. Cost of
equipment sales in the current year is principally comprised of approximately
$3.4 million of material costs and estimated warranty costs for the 195 video
servers for the Georgia schools project and approximately $1.4 million of
material costs related to network equipment onboard two Carnival ships. Cost of
equipment sales of $1,801,037 (unaudited) for the twelve months ended June 30,
1999 is comprised principally of material costs for four Swissair Entertainment
Networks. Cost of service income of $61,978 for the year ended June 30, 2000 is
principally attributable to video content costs. Cost of service income for the
twelve months ended June 30, 1999 is related to programming services provided to
Swissair.
Cost of equipment sales for the twelve months ended June 30, 1999 was
$1,801,037 (unaudited), a decrease of $13,722,245 (or 88%) compared to
$15,523,282 for the fiscal year ended October 31, 1998. Cost of equipment sales
of $1,801,037 (unaudited) for the year ended June 30, 1999 is comprised
principally of material costs for four Swissair Entertainment Networks. Cost of
equipment sales of $15,523,282 for fiscal 1998 includes materials, installation
and maintenance costs, as well as estimated one-year warranty costs and costs of
upgrades to the Swissair Entertainment Networks that the Company was
contractually committed to providing to Swissair.
GENERAL AND ADMINISTRATIVE COSTS
General and administrative expenses for the year ended June 30, 2000 were
$9,827,804, a decrease of $53,752 (or 1%) compared to expenses of $9,881,556
(unaudited) for the twelve months ended June 30, 1999. The decrease in expenses
in the current fiscal year can be principally attributed to a $3.1 million
(unaudited) severance payment recorded in the twelve months ended June 30, 1999
for three former executives of the former IED as well as a $1.6 million
(unaudited) write-off in the twelve months ended June 30, 1999 of certain
consulting agreements determined to have no future value, offset in fiscal 2000
by an increase in payroll and benefit costs generated by an approximate 180%
increase in personnel, increases in depreciation expense, the addition of the
Company's Philadelphia office and expenses incurred by the Company's UK
subsidiary. Significant components of general and administrative expenses
include payroll costs and legal and professional fees.
General and administrative expenses for the twelve months ended June 30,
1999 were $9,881,556 (unaudited), an increase of $861,684 (or 10%) compared to
expenses of $9,019,872 for the year ended October 31, 1998. Significant
components of general and administrative expenses include costs of consulting
agreements, legal and professional fees, and corporate insurance costs.
RESEARCH AND DEVELOPMENT EXPENSES
There were no research and development expenses in the year ended June 30,
2000. There were no research and development expenses for the twelve months
ended June 30, 1999 (unaudited), compared to $1,092,316 for the year ended
October 31, 1998. The decrease in expenses in 1999 from 1998 reflects the
Company's decision not to develop the next generation of the Inflight
Entertainment Network and the resulting reduction in staff and professional
fees. We expect a substantial increase in research and development costs in
future periods as we continue to develop new technologies and product features.
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REVERSAL OF WARRANTY, MAINTENANCE AND COMMISSION ACCRUALS
For the twelve months ended June 30, 1999 the Company recorded warranty,
maintenance, commission and support cost accrual adjustments of $5,117,704
(unaudited), $504,409 (unaudited), $303,321 (unaudited) and $1,225,959
(unaudited), respectively. Such adjustments to prior period estimates, which
totaled $7,151,393 (unaudited), resulted from an evaluation of specific
contractual obligations related to Swissair and discussions between the new
management of the Company and other parties related to such contracts. Based on
the results of the Company's findings during fiscal 1999, such accruals were no
longer considered necessary.
NON-CASH COMPENSATION EXPENSE
Non-cash compensation expense of $1,005,232 for the year ended June 30,
2000 is comprised of an $85,000 expense for a former employee as part of a
severance package, charges of $132,821 for modifications of stock option awards
for two former employees and charges totaling $787,411 related to the issuance
of Common Stock purchase warrants and Common Stock for financial advisory
services.
PROVISION FOR DOUBTFUL ACCOUNTS
There were no provisions for doubtful accounts for the year ended June 30,
2000 compared to $28,648 (unaudited) for the twelve months ended June 30, 1999.
The provisions in the previous fiscal year resulted from entertainment
programming services provided to Swissair for which the Company has not been
paid.
Provisions for doubtful accounts for the twelve months ended June 30, 1999
were $28,648 (unaudited), compared to zero for the year ended October 31, 1998.
Twelve months ended June 30, 1999 provisions resulted from entertainment
programming services provided to Swissair.
SPECIAL CHARGES
Special charges for the year ended June 30, 2000 were $2,156,205 compared
to $331,590 (unaudited) for the previous twelve month period. Fiscal 2000
special charges are principally comprised of costs associated with two Carnival
ships resulting from the write-off of certain inventory, refurbishment of
equipment and estimated de-installation obligations. See discussion of Carnival
in "Liquidity and Capital Resources" below. Special charges for the twelve month
period ended June 30, 1999 are comprised of $521,590 (unaudited) in assets
written off related to Swissair, offset by the recovery of $190,000 (unaudited)
that was recognized during the quarter ended September 30, 1998 as a result of a
reduction in the number of entertainment networks installed in Swissair aircraft
requiring maintenance.
Special charges for the twelve months ended June 30, 1999 were $331,590
(unaudited), compared to $400,024 for the year ended October 31, 1998. Special
charges for the year ended June 30, 1999 are comprised of $521,590 (unaudited)
in assets written off related to Swissair, offset by the recovery of $190,000
(unaudited) that was recognized during the quarter ended September 30, 1998 as a
result of a reduction in the number of entertainment networks installed in
Swissair aircraft requiring maintenance. Special charges in fiscal 1998
primarily resulted from equipment write-offs of $1,006,532. The write-offs were
for excess computers, furniture and other equipment that the Company was not
utilizing in its operations. The equipment write-offs were partly offset by a
recovery of special charges expensed in fiscal 1997. During fiscal 1998, a
recovery of $190,000 was recognized as a special charge credit as a result of a
reduction in the number of Entertainment Networks requiring maintenance. The
Company also recognized a recovery of $416,508 related to Swissair's decision to
not develop the system for the front row in the economy sections of its
aircraft.
AMORTIZATION OF INTANGIBLES
Amortization expense for the year ended June 30, 2000 was $912,553, an
increase of $837,572 (or 1,117%) compared to amortization expense of $74,981
(unaudited) for the twelve months ended June 30, 1999. The increase in
intangible amortization in the current fiscal year is due to goodwill
amortization recorded during the year which resulted from the May 1999
18
<PAGE>
acquisition transaction described above. Effective May 1, 2000, we revised our
estimate of the remaining useful life of goodwill from ten years to five years
as a result of economic events which occured during the period. Had the Company
assumed a five-year life for goodwill amortization at the Transition date,
additional expense of approximately $593,000 would have been recorded for the
year-ended June 30, 2000, and approximately $712,000 for each of the remaining
years.
Amortization expense was $74,981 (unaudited) for the twelve months ended
June 30, 1999, compared to zero for the year ended October 31, 1998.
INTEREST EXPENSE
Interest expense for the year ended June 30, 2000 was $4,602,183 compared
to $86,373 (unaudited) for the twelve months ended June 30, 1999. Interest
expense for the current fiscal year can be attributed principally to non-cash
expenses related to a beneficial conversion attributed to the revolving credit
facility with Global, whereas interest expense for the previous fiscal year can
be attributed to long-term debt obligations as well as capital leases for
furniture which expired in September 1999.
Interest expense was $86,373 (unaudited) for the twelve months ended June
30, 1999 compared to $11,954 for the year ended October 31, 1998. The twelve
month 1999 expense can be attributed principally to long-term debt obligations,
whereas the fiscal 1998 expense is attributable to the Company's capital leases
for furniture that expire in September 1999.
INTEREST INCOME
Interest income for the year ended June 30, 2000 was $109,001 compared to
$154,629 (unaudited) for the twelve months ended June 30, 1999. Interest income
for the current fiscal year was principally generated from short-term
investments of working capital, whereas interest income for the previous fiscal
year is principally attributed to Swissair extended warranty billings.
Interest income for the twelve months ended June 30, 1999 was $154,629
(unaudited) compared to $53,465 for the year ended October 31, 1998. Fiscal 1999
and fiscal 1998 interest income is principally attributed to Swissair extended
warranty billings.
OTHER INCOME (EXPENSE)
Other expense for the year ended June 30, 2000 was $19,386. This is
comprised of income resulting from the sale of equipment, offset by expense
resulting from a loss on the buyout of a capital lease for furniture, losses
incurred on the sale of two buildings located in Georgia and a loss incurred on
the buyout of a vehicle lease.
Other expense for the twelve months ended June 30, 1999 was $567,307
(unaudited), resulting from furniture and equipment write-offs in October 1998.
Other income of $10,179 for the year ended October 31, 1998 represents
proceeds from the sale of scrapped inventory.
LIQUIDITY AND CAPITAL RESOURCES
We expect to use a significant amount of cash in the next twelve months.
Cash will be used primarily to repay existing vendors, finance anticipated
operating losses resulting from efforts to build a customer base and develop
operations, and to make capital expenditures required for sales of our systems.
Our consolidated financial statements are prepared using generally accepted
accounting principles applicable to a going concern which contemplate the
realization of assets and liquidation of liabilities in the normal course of
business. We have incurred net losses from operations for two of the last three
periods, had an accumulated deficit at June 30, 2000 as a result of efforts to
build our customer base and develop our operations. Management believes that our
19
<PAGE>
current cash balances, the $5 million credit facility with Global Technologies
(of which approximately $2.7 million remains available as of September 29,
2000), and currently available external sources of financing will not be
sufficient to meet our currently anticipated cash requirements for operations
for the next 12 months. A substantial portion of our accounts payable are past
due and many suppliers have imposed cash on delivery terms. We are in
discussions with private equity sources which, if transactions are consumated,
together with the Global Technologies credit facility and currently available
external sources of financing, should provide sufficient short-term funding. Our
inability to draw on the credit facility with Global Technologies, to obtain
funds pursuant to the currently available external sources of financing, or not
complete certain private placement transactions, would have a material adverse
effect on our operating results, financial condition and ability to continue as
a going concern.
Global Technologies does not currently have sufficient cash for us to
borrow under the credit facility and no assurance can be given that currently
available external sources of financing will have the resources necessary to
meet its commitments as we draw down from time to time pursuant to our private
equity line, or that any other financings will be consumated. Additionally, any
increase in our growth rate, shortfalls in anticipated revenues, increases in
anticipated expenses, or significant acquisition or expansion opportunities
could have a material adverse effect on our liquidity and capital resources and
would require us to raise additional capital from public or private equity or
debt sources in order to finance operating losses, anticipated growth, and
contemplated capital expenditures and expansions.
We have significant expansion plans which we intend to fund with the
facilities discussed above; however, if there is any delay in the anticipated
closing of these facilities or any shortfall, we will not engage in such
expansion until adequate capital sources have been arranged. If such sources of
financing are insufficient or unavailable, we will be required to modify our
growth and operating plans or scale back operations to the extent of
unanticipated opportunities, such as acquisitions of complementary businesses or
the development of new products, or otherwise respond to unanticipated
competitive pressures. There can be no assurance that we will be able to raise
any such capital on terms acceptable to us or at all.
We expect to continue to focus on developing and expanding our enhanced
broadband information and entertainment systems while continuing to expand our
current operation's market penetration. Accordingly, we expect that our capital
expenditures and cost of revenues and depreciation and amortization expenses
will continue to increase significantly, all of which could have a negative
impact on short-term operating results. In addition, we may change our strategy
to respond to a changing competitive environment. There can be no assurance that
growth in our revenue or market penetration will continue, that our expansion
efforts will be profitable, or that we will be able to achieve or sustain
profitability or positive cash flow. Further, we will require substantial
financing to continue as a going concern, accomplish any significant acquisition
or merger transaction, and provide for working capital to operate our current
and proposed expanded operations until profitability is achieved, if ever.
We are currently using our working capital to finance equipment purchases
and other expenses associated with the delivery and installation of our
products, and general and administrative costs.
Prior to June 30, 1999, our primary source of funding had been through
contributed capital from Global Technologies. In August 1999, we received an
order for $5.4 million for the manufacture, delivery and installation of 195 of
our Cheetah(R) multimedia video servers in connection with the Georgia MRESA Net
2000 project; and a service order under an agreement with Carnival for
installation of a second CruiseView(TM) system. In addition, as of the date of
20
<PAGE>
this report, we have received orders for the installation of our InnView(TM)
system in eleven hotels within the United States. We have received the full
payment of $5.4 million in connection with the Net 2000 project. We received
payments from Carnival for the two ships (see Notes to Consolidated Financial
Statements, Note 20). Working capital will continue to decrease as we continue
to invest in equipment for orders under the agreements with the hotel orders,
invest in business development, and invest in additional equipment to the extent
we are successful in generating additional orders for sales of our systems,
which are longer term by nature.
During the year ended June 30, 2000, we used $4,755,647 of cash for
operating activities, an increase of $1,657,700 from the $3,097,947 of cash used
for the Transition Period ended June 30, 1999. The cash utilized in operations
during the year ended June 30, 2000 resulted primarily from the net loss,
partially offset by increases in accounts payable, non-cash interest and special
charges. The cash utilized in operations during the Transition Period ended June
30, 1999 resulted primarily from reversal of warranty, maintenance and
commission accruals and an increase in accounts payable, partially offset by
increases in inventory and deferred revenue.
Cash flows used in investing activities were $2,397,851 during the year
ended June 30, 2000, an increase of $2,091,839 from the $306,012 of cash used
for the Transition Period ended June 30, 1999. The increase in cash used
resulted primarily from the purchase of equipment used for installations of our
system into hotel properties, partially offset by sale of investment securities
in the quarter ended December 31, 1999 and proceeds from the sale of two
buildings held for sale (one in the first quarter, and one in the second
quarter).
During the year ended June 30, 2000, cash provided by financing activities
was $4,990,241 a decrease of $1,150,876 from the $6,141,117 of cash provided for
the Transition Period ended June 30, 1999. The decrease in cash provided in the
current fiscal year resulted primarily from borrowings under the credit facility
with Global Technologies, advances received from a related party, as well as
advances under an equity purchase agreement, offset by payments made on notes
payable.
Prior to the acquisition of the Interactive Entertainment Division, we
entered into a secured promissory note with Global Technologies in the principal
amount of $750,000, bearing interest at a rate of 9.5% per annum, and a related
security agreement granting Global Technologies a security interest in our
assets. This promissory note was converted into 886,000 shares of our Common
Stock by Global Technologies in December 1999.
In July and August 1999, Global Technologies purchased all of our Series A
and E notes and the Series D notes, respectively, from the holders of such
notes. Concurrent with such purchase by Global Technologies, we executed several
allonges to the promissory note which cancelled such Series Notes and rolled the
principal balance, plus accrued but unpaid interest, penalties and redemption
premiums on the Series Notes into the principal balance of the promissory note.
Subsequent to May 18, 1999, Global Technologies had also advanced working
capital to us in the form of intercompany advances. In August 1999, we executed
an allonge to the promissory note which rolled the intercompany advances into
the principal balance of the promissory note and granted Global Technologies the
ability to convert the promissory note directly into shares of our common stock
as an administrative convenience.
On August 24, 1999, the board of directors of Global Technologies approved
the conversion of the promissory note into shares of our common stock. Such
conversion, to the extent it exceeded approximately one million shares of our
common stock on August 24, 1999, was contingent upon receiving shareholder
approval to increase our authorized share capital. This increase in authorized
share capital was subsequently approved on September 17, 1999 at the Special
Meeting of our shareholders. Accordingly, in December 1999, we issued to Global
Technologies 4,802,377 shares of our common stock based on the conversion date
of August 24, 1999.
21
<PAGE>
On August 24, 1999, the board of directors of Global Technologies approved
a $5 million secured revolving credit facility by and between Global
Technologies and us. This credit facility provides that we may borrow up to $5
million for working capital and general corporate purposes at the prime rate of
interest plus 3%. The credit facility matures in September 2001. We paid an
origination fee of $50,000 to Global Technologies and will pay an unused line
fee of 0.5% per annum. The credit facility is secured by all of our assets and
is convertible, at Global Technologies' option, into shares of our common stock
at a price equal to the lesser of 66.7% of the trailing five-day average share
price of the preceding 20 days, $1.50 per share, or any lesser amount at which
common stock has been issued to third parties. Pursuant to Nasdaq rules, Global
Technologies may not convert borrowings under the credit facility into shares of
our common stock in excess of 19.99% of the number of shares of common stock
outstanding on August 24, 1999, without shareholder approval. As of June 30,
2000, $2,350,000 was outstanding under the credit facility. As of June 30, 2000,
Global Technologies did not have sufficient cash for us to borrow the full $5
million under the credit facility. Should we be unable to borrow funds under the
credit facility, it could result in a material adverse effect on our operating
results and financial condition.
In September 1999, we sold one of our two buildings in Alpharetta, Georgia.
The net proceeds from the sale, plus cash of approximately $80,000 was used by
us to repay a note payable due April 19, 2001 in the principal amount of
$470,000. The sale of the second building occurred in November 1999. The net
proceeds of approximately $367,000 from sale were used to retire a note payable
due 2009 in the principal amount of $217,000.
In September 1998, the Company entered into a Turnkey Agreement (the
"Carnival Agreement") with Carnival Corporation ("Carnival") for the purchase,
installation and maintenance of its advanced cabin entertainment and management
system for the cruise industry ("CruiseView(TM)") on a minimum of one Carnival
Cruise Lines ship. During the four-year period commencing on the date of the
Carnival Agreement, Carnival had the right to designate an unspecified number of
additional ships for the installation of CruiseView(TM). The cost per cabin for
CruiseView(TM) purchase and installation on each ship was provided for in the
Carnival Agreement. In December 1998, Carnival ordered the installation of
CruiseView(TM) on one Carnival Cruise Lines "Fantasy" class ship which has been
in operational use since August 1999. In August 1999, Carnival ordered the
installation of CruiseView(TM) on one Carnival Cruise Lines "Destiny" class ship
which was in operational use from October 1999 through March 2000. Under the
terms of the agreement, the Company was to receive payment for 50% of the sales
price of the system in installments through commencement of operation of the
system. Recovery of the remaining sales price of the system was to be achieved
through the receipt of the Company's 50% share of net profits, as defined in the
Carnival Agreement, generated by the system over future periods.
The terms of the Carnival Agreement provided that Carnival may return the
CruiseView(TM) system within the acceptance period, as defined in the Carnival
Agreement, or for breach of warranty. The acceptance period for the Fantasy and
Destiny class ships were twelve months and three months, respectively, from
completion of installation and testing, which occurred in February 1999 and
October 1999, respectively. The initial warranty period for these systems was
three years. As of March 31, 2000, the Company had recorded deferred revenue of
approximately $2.1 million related to the two Carnival ships.
Beginning in the quarter ended March 31, 2000, the Company had experienced
costs in excess of those recoverable under the Carnival Agreement. Given these
costs, and ongoing technical issues, the Company notified Carnival of its desire
to renegotiate the Carnival Agreement. During these discussions, Carnival
notified the Company in a letter dated April 24, 2000 that it sought to
terminate the Carnival Agreement and sought to assert certain remedies
thereunder. On September 25, 2000, the Company entered into a Master Settlement
Agreement and Mutual Release with Carnival (the "Settlement Agreement"). The
Settlement Agreement specifies that the Company and Carnival agree: (i) To
terminate the Carnival Agreement; (ii) to negotiate in good faith to enter into
a New Agreement; (iii) that the Company will issue to Carnival a one-year
convertible note payable in the principal amount of $550,000; (iv) to mutually
release each party from any prior claims; and (v) the Company shall retain
ownership of any and all equipment (other than wiring and switching equipment
installed for networking purposes which Carnival purchased and paid in full
pursuant to the Carnival Agreement) installed on any Carnival ship.
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<PAGE>
Based on the above, the Company recorded revenue of $1.4 million for the
value of networking equipment purchased by Carnival, cost of revenue in an equal
amount by applying the cost recovery method of accounting and special charges of
approximately $2.1 million resulting from the Settlement Agreement. The Company
recorded a special charge reflecting the write-off of: (i) all remaining
inventory associated with Carnival as substantial uncertainty exists regarding
its realizability (approximately $2.1 million); (ii) all costs associated with
the deinstallation and removal of equipment from the two ships (approximately
$85,000) and (iii) all costs associated with the refurbishment of certain
equipment such that the equipment may be re-deployed to other customers
($174,000). Special charges were offset by the reversal of deferred revenue of
$190,000 which the Company was not required to return to Carnival, and warranty
accruals for which the Company has no continuing obligation.
Pursuant to the Settlement Agreement, the Company and Carnival continued
discussions with respect to a New Agreement which would cover the installation
of the Company's latest CruiseView(TM) technology on the "Fantasy" class ship
discussed above, and contractual terms more favorable to the Company than the
Carnival Agreement, including a longer-term and multiple ship arrangement. The
Company believes its new technology improves the Company's ability to create
multiple new content and commerce-based revenue streams, and to establish a
business relationship providing appropriate returns to each partner. However,
while the Company is optimistic about the discussions, there is no assurance
that the Company will be successful in reaching a mutually satisfactory
resolution of the Carnival Agreement and in securing a new, more favorable
long-term contract with Carnival. Notwithstanding the above, the Company
continues to operate its CruiseView(TM) system aboard one Carnival Fantasy class
ship on a month-to-month basis and will continue to do so as long as the
economics are beneficial to the Company and Carnival.
INFLATION AND SEASONALITY
We do not believe that we are significantly impacted by inflation. Our
operations are not seasonal in nature, except to extent fluctuations in
quarterly operating results occur due to the cyclical nature of government
funding to be obtained in connection with education programs.
RISKS ASSOCIATED WITH YEAR 2000
In prior periods, the Company discussed the nature and progress of its
plans to become Year 2000 ready. In late 1999, the Company completed the
remediation and testing of its critical computer dependent systems. Through June
30, 2000, the Company has experienced no significant disruptions in critical
information technology and non-information technology systems and believes those
systems successfully responded to the Year 2000 date change. The Company is not
aware of any material problems resulting from Year 2000 issues, either with its
products, its internal systems, or the products and services of third parties.
The Company will continue to monitor its mission critical computer applications
and those of our suppliers and vendors throughout the year 2000.
FORWARD-LOOKING INFORMATION
This Report contains certain forward-looking statements and information
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934. The cautionary statements made in this
Report should be read as being applicable to all related forward-looking
statements wherever they appear in this Report. Forward-looking statements, by
their very nature, include risks and uncertainties. Accordingly, the Company's
actual results could differ materially from those discussed herein. A wide
variety of factors could cause or contribute to such differences and could
adversely impact revenues, profitability, cash flows and capital needs. Such
factors, many of which are beyond the control of the Company, include the
following: the Company's success in obtaining new contracts; the volume and type
of work orders that are received under such contracts; the accuracy of the cost
estimates for the projects; the Company's ability to complete its projects on
time and within budget; levels of, and ability to, collect accounts receivable;
availability of trained personnel and utilization of the Company's capacity to
complete work; competition and competitive pressures on pricing; and economic
conditions in the United States and in other regions served by the Company.
23
<PAGE>
NEW ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivatives and Similar Financial Instruments and for Hedging
Activities", to establish accounting and reporting standards for derivative
instruments and for hedging activities. It requires that an entity recognize all
derivatives as either assets or liabilities on the balance sheet and measure
those instruments at fair value. This new standard, as amended by related SFAS
Nos. 137 and 138, will be effective for the Company for its fiscal year ending
June 30, 2001. We are currently evaluating the impact of SFAS No. 133.
In March 2000, the Financial Accounting Standards Board issued FASB
Interpretation No. 44, Accounting for Certain Transactions Involving Stock
Compensation (an interpretation of APB 25). This interpretation clarifies the
application of APB No. 25 by clarifying the definition of an employee, the
determination of non-compensatory plans and the effect of modifications to stock
options. This interpretation is effective July 1, 2000 and is not expected to
have a material effect on the Company's consolidated financial statements.
ITEM 7 - FINANCIAL STATEMENTS
The financial statements and schedules are included herewith commencing on
page F-1.
ITEM 8 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
There are no items or circumstances to be disclosed under this Item 8.
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<PAGE>
PART III
ITEM 9 - DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
The information required by Item 9 of Form 10-KSB with respect to
identification of directors is incorporated by reference from the information
contained in the sections captioned "Election of Directors" "Management" and
"Compliance with Section 16(a) of the Exchange Act" in TNCi's definitive Proxy
Statement for the Annual Meeting of Stockholders to be held November 16, 2000
(the "Proxy Statement"), a copy of which will be filed with the Securities and
Exchange Commission before the meeting date.
ITEM 10 - EXECUTIVE COMPENSATION
The information required by Item 10 of Form 10-KSB is incorporated by
reference from the information contained in the section captioned "Executive
Compensation and Other Matters" in the Proxy Statement.
ITEM 11 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 11 of Form 10-KSB is incorporated by
reference from the information contained in the section captioned "General
Information" in the Proxy Statement.
ITEM 12 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 12 of Form 10-KSB is incorporated by
reference from the information contained in the section captioned "Certain
Relationships and Related Transactions" in the Proxy Statement.
ITEM 13 - EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
The following Exhibits are filed as part of this Annual Report on Form
10-KSB pursuant to Rule 601 of Regulation S-B.
<TABLE>
<CAPTION>
Exhibit
Number Description Reference
------ ----------- ---------
<S> <C> <C>
2.1 Asset Purchase and Sale Agreement with Interactive Flight Technologies, Inc.
(Global Technologies) dated April 29, 1999 (1)
2.2 First Amendment to Asset Purchase and Sale Agreement, dated April 29, 1999 (1)
3.1.1 Second Amended and Restated Articles of Incorporation (2)
3.1.2 Articles of Amendment to the Articles of Incorporation (re: Series A Preferred) (3)
3.1.3 Articles of Amendment to the Articles of Incorporation (re: Series B Preferred) (4)
3.1.4 Articles of Amendment to the Articles of Incorporation (re: elimination of Series
A preferred) (5)
3.1.5 Articles of Amendment to the Articles of Incorporation (re: Amendment to Series B
Preferred) (6)
3.1.6 Articles of Amendment to the Articles of Incorporation (re: Series C Preferred) (6)
3.1.7 Articles of Amendment to the Articles of Incorporation (re: Series D Preferred) (7)
3.1.8 Articles of Amendment to the Second Amended and Restated Articles of
Incorporation (re: increase of authorized shares) (8)
3.1.9 Articles of Amendment to the Second Amended and Restated Articles of
Incorporation (re: increase in shares of Series C Preferred) (8)
3.1.10 Articles of Amendment to the Articles of Incorporation (re: Series E Preferred)
3.2 Amended and Restated Bylaws (2)
</TABLE>
25
<PAGE>
<TABLE>
<CAPTION>
Exhibit
Number Description Reference
------ ----------- ---------
<S> <C> <C>
10.1 Employment Agreement, dated October 31, 1998, by and between the corporation and
Wilbur L. Riner (4)
10.2 Addendum and Modification to Employment Agreement, dated May 14, 1999, by and
between the corporation and Wilbur L. Riner (7)
10.3 Employment Agreement, dated October 31, 1998, by and between the corporation and
James E. Riner (4)
10.4 Addendum and Modification to Employment Agreement, dated May 14, 1999, by and
between the corporation and James E. Riner (7)
10.5 Employment Agreement, dated October 31, 1998, by and between the corporation and
Bryan R. Carr (4)
10.6 Employment Agreement, effective June 11, 1999, by and between the corporation and
Frank Gomer (7)
10.7 Separation Agreement and Release of All Claims , effective April 12, 2000, by and
between the corporation and Frank Gomer (5)
10.8 Employment Agreement, effective June 11, 1999, by and between the corporation and
Morris C. Aaron (7)
10.9 1994 Employee Stock Option Plan, including form of Stock Option Agreement (9)
10.10 1995 Stock Option Plan for Non-Employee Directors (10)
10.11 Securities Purchase Agreement dated as of October 23, 1998, between the Shaar
Fund Ltd. and the corporation (11)
10.12 Registration Rights Agreement dated as of October 23, 1998, between Shaar and the
corporation (11)
10.13 Warrant Agreement dated October 23, 1998, between Shaar and the corporation (11)
10.14 Securities Purchase Agreement dated as of December 28, 1998, between Cache
Capital and the corporation (4)
10.15 Registration Rights Agreement dated as of December 28, 1998, between Cache
Capital and the corporation (4)
10.16 Service Agreement between The Network Connection and Stephen J. Ollier (12)
10.17 Secured Promissory Note, dated January 25, 1999, made in favor of Interactive
Flight Technologies, Inc. (6)
10.18 First Allonge to Secured Promissory Note, dated May 10, 1999, made in favor of
Interactive Flight Technologies, Inc. (6)
10.19 Second Allonge to Secured Promissory Note, dated May 10, 1999, made in favor of
Interactive Flight Technologies, Inc. (6)
10.20 Third Allonge to Secured Promissory Note, dated May 10, 1999, made in favor of
Interactive Flight Technologies, Inc. (6)
10.21 Fourth Allonge to Secured Promissory Note, dated May 10, 1999, made in favor of
Interactive Flight Technologies, Inc. (6)
10.22 Amendment No. 1 to Registration Rights Agreement, dated May 10, 1999, between the
corporation and Interactive Flight Technologies, Inc. (6)
10.23 Fifth Allonge to Secured Promissory Note, dated July 16, 1999, made in favor of
Interactive Flight Technologies, Inc. (7)
10.24 Sixth Allonge to Secured Promissory Note, dated August 9, 1999, made in favor of
Interactive Flight Technologies, Inc. (7)
10.25 Seventh Allonge to Secured Promissory Note, dated August 24, 1999, made in favor
of Interactive Flight Technologies, Inc. (7)
10.26 Revolving Credit Note in the aggregate amount of $5,000,000 in favor of
Interactive Flight Technologies, Inc. (7)
10.27 Agreement between Carnival Corporation and The Network Connection (12)
10.28 Master Settlement Agreement and Mutual Release (Carnival Corporation) *
10.29 Convertible Note (Carnival Corporation) *
10.30 Agreement between Embassy Suites and The Network Connection (12)
10.31 Agreement between Radisson Resort and The Network Connection (12)
10.32 Amended and Restated Seventh Allonge to Secured Promissory Note, dated
December 10, 1999. (5)
10.33 Employment Agreement between Robert Pringle and the corporation, dated
March 6, 2000. (13)
10.34 Employment Agreement between Jay Rosan and the corporation, dated
March 6, 2000. (13)
</TABLE>
26
<PAGE>
<TABLE>
<CAPTION>
Exhibit
Number Description Reference
------ ----------- ---------
<S> <C> <C>
10.35 Employment Agreement between Richard Genzer and the corporation, dated
March 6, 2000. (13)
10.36 Option Agreement between Robert Pringle and the corporation, dated March 6, 2000. (13)
10.37 Option Agreement between Jay Rosan and the corporation, dated March 6, 2000. (13)
10.38 Option Agreement between Richard Genzer and the corporation, dated March 6, 2000. (13)
10.39 Registration Rights Agreement between the corporation and Robert Pringle, Jay
Rosan and Richard Genzer, dated March 6, 2000. (13)
10.40 Agreement between Brisbane Lodging LP DBA Radisson Hotel San Francisco Airport at
Sierra Point and the corporation. (13)
10.41 Master Facility Agreement by and between the corporation and Fusion Capital Fund
II, LLC dated as of June 1, 2000. (14)
16.1 Letter on Change in Certifying Accountant (12)
21.1 Schedule of Subsidiaries *
23.1 Consent of KPMG LLP *
27 Financial Data Schedule *
</TABLE>
----------
* Filed herewith.
(1) Incorporated by reference, filed as an exhibit with The Network
Connection's Current Report on Form 8-K on May 18, 1999.
(2) Incorporated by reference, filed as an exhibit with The Network
Connection's Current Report on Form 8-K on June 21, 1996.
(3) Incorporated by reference, filed as an exhibit with The Network
Connection's Current Report on Form 8-K on June 9, 1998.
(4) Incorporated by reference, filed as an exhibit with The Network
Connection's Annual Report on Form 10-KSB for the fiscal year ended
December 31, 1998 on April 15, 1999.
(5) Incorporated by reference, filed as an exhibit with The Network
Connection's registration statement on Form SB-2 on February 23, 2000. SEC
File No. 333-30980.
(6) Incorporated by reference, filed as an exhibit with the Network
Connection's Quarterly Report on Form 10-QSB for the fiscal quarter ended
March 31, 1999.
(7) Incorporated by reference, filed as an exhibit with The Network
Connection's Annual Report on Form 10-KSB for the fiscal year ended June
30, 1999 on October 14, 1999.
(8) Incorporated by reference, filed as an exhibit with The Network
Connection's Quarterly Report 10-QSB for the quarter ended September 30,
1999 on November 17, 1999.
(9) Incorporated by reference, filed as an exhibit with The Network
Connection's registration statement on Form SB-2 on October 26, 1994. SEC
File No. 33-85654.
(10) Incorporated by reference, filed as an exhibit with The Network
Connection's Annual Report on Form 10-KSB for the fiscal year ended
December 31, 1995.
(11) Incorporated by reference, filed as an exhibit with the corporation's
Quarterly Report on Form 10-QSB for the fiscal quarter ended September 30,
1998 on November 16, 1998.
(12) Incorporated by reference to the respective exhibits filed with The Network
Connection's Quarterly Report on Form 10-QSB for the fiscal quarter ended
December 31, 1999 on February 14, 2000.
(13) Incorporated by reference, filed as an exhibit with the corporation's
Quarterly Report on Form 10-QSB for the fiscal quarter ended March 31, 2000
on May 15, 2000.
(14) Incorporated by reference, filed as an exhibit with The Network
Connection's Amendment No. 1 to its registration statement on Form SB-2 on
June 7, 2000. SEC File No. 333-30980.
(b) CURRENT REPORTS ON FORM 8-K
None.
27
<PAGE>
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.
THE NETWORK CONNECTION, INC.
Dated: October 5, 2000 By: /s/ IRWIN L. GROSS
------------------------------------
Irwin L. Gross,
Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ IRWIN L. GROSS Chairman of the Board October 5, 2000
----------------------------
Irwin L. Gross
/s/ MORRIS C. AARON Executive Vice President October 5, 2000
---------------------------- and Chief Financial Officer
Morris C. Aaron
/s/ ROBERT PRINGLE President, Chief Operating October 5, 2000
---------------------------- Officer and Director
Robert Pringle
/s/ STEPHEN SCHACHMAN Director October 5, 2000
----------------------------
Stephen Schachman
/s/ M. MOSHE PORAT Director October 5, 2000
----------------------------
M. Moshe Porat
26
<PAGE>
THE NETWORK CONNECTION, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Independent Auditors' Report.................................................F-2
Consolidated Balance Sheets as of June 30, 2000 and 1999.....................F-3
Consolidated Statements of Operations for the Year Ended
June 30, 2000, the Transition Period Ended June 30, 1999
and the Year Ended October 31, 1998........................................F-4
Consolidated Statements of Cash Flows for the Year Ended
June 30, 2000, the Transition Period Ended June 30, 1999
and the Year Ended October 31, 1998........................................F-5
Consolidated Statements of Stockholders' Equity (Deficiency)
and Comprehensive Income for the Year Ended June 30, 2000,
the Transition Period Ended June 30, 1999 and the Year Ended
October 31, 1998...........................................................F-6
Notes to Consolidated Financial Statements...................................F-7
F-1
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Stockholders and Board of Directors
The Network Connection, Inc.:
We have audited the accompanying consolidated balance sheets of The Network
Connection, Inc. and Subsidiary (the Company) as of June 30, 2000 and 1999 and
the related consolidated statements of operations, stockholders' equity
(deficiency) and comprehensive income and cash flows for the year ended June 30,
2000, the Transition Period ended June 30, 1999 and the year ended October 31,
1998. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the consolidated financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall consolidated financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above, present
fairly, in all material respects, the financial position of The Network
Connection, Inc. and Subsidiary at June 30, 2000 and 1999 and the results of its
operations and its cash flows for the year ended June 30, 2000, the Transition
Period ended June 30, 1999 and the year ended October 31, 1998, in conformity
with accounting principles generally accepted in the United States of America.
The accompanying consolidated financial statements have been prepared assuming
that The Network Connection, Inc. and Subsidiary will continue as a going
concern. As discussed in Note 2 to the consolidated financial statements, the
Company has incurred net losses from operations and has a working capital
deficiency and an accumulated deficit that raises substantial doubt about its
ability to continue as a going concern. Management's plans in regard to these
matters are also described in Note 2. The consolidated financial statements do
not include any adjustments that might result from the outcome of this
uncertainty.
/s/ KPMG LLP
Phoenix, Arizona
September 27, 2000
F-2
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
JUNE 30, JUNE 30,
Assets 2000 1999
------------ ------------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 579,721 $ 2,751,506
Restricted cash 475,915 446,679
Investment securities -- 302,589
Accounts receivable 55,951 75,792
Notes receivable from related parties -- 98,932
Inventories -- 1,400,000
Prepaid expenses 336,721 169,429
Assets held for sale -- 800,000
Due from affiliate 73,607 --
Other current assets 74,566 173,999
------------ ------------
Total current assets 1,596,481 6,218,926
Note receivable from related party 117,612 75,000
Property and equipment, net 3,810,649 1,338,580
Intangibles, net 6,697,955 7,119,806
Other assets 1,246,002 150
------------ ------------
Total assets $ 13,468,699 $ 14,752,462
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 4,338,943 $ 1,681,771
Accrued liabilities 2,924,797 2,209,682
Deferred revenue -- 365,851
Accrued product warranties 141,796 --
Dividends payable 140,000 --
Notes payable 4,744 24,391
Notes payable to related parties 800,000 68,836
------------ ------------
Total current liabilities 8,350,280 4,350,531
Notes payable -- 3,467,045
Notes payable to related parties 2,350,000 1,647,692
------------ ------------
Total liabilities 10,700,280 9,465,268
------------ ------------
Commitments and contingencies
Stockholders' equity:
Series B preferred stock par value $0.01 per share, 1,500 shares
designated, issued and outstanding 15 15
Series C preferred stock par value $0.01 per share, 1,600 shares
designated; zero and 800 issued and outstanding, respectively -- 8
Series D preferred stock par value $0.01 per share, 2,495,400
designated, issued and outstanding 24,954 24,954
Common stock par value $0.001 per share, 40,000,000 shares authorized;
14,460,212 and 6,339,076 issued and outstanding, respectively 14,460 6,339
Additional paid-in capital 102,053,251 88,316,945
Accumulated other comprehensive income:
Loss on foreign currency translation (11,521) --
Net unrealized loss on investment securities -- (526)
Accumulated deficit (99,312,740) (83,060,541)
------------ ------------
Total stockholders' equity 2,768,419 5,287,194
------------ ------------
Total liabilities and stockholders' equity $ 13,468,699 $ 14,752,462
============ ============
</TABLE>
See accompanying notes to consolidated financial statements.
F-3
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
TRANSITION
YEAR ENDED PERIOD ENDED YEAR ENDED
JUNE 30, JUNE 30, OCTOBER 31,
2000 1999 1998
------------ ------------ ------------
<S> <C> <C> <C>
Revenue:
Equipment sales $ 6,983,787 $ 875,957 $ 18,038,619
Service income 107,873 82,650 778,343
------------ ------------ ------------
7,091,660 958,607 18,816,962
------------ ------------ ------------
Costs and expenses:
Cost of equipment sales 4,867,519 1,517,323 15,523,282
Cost of service income 61,978 480 13,789
General and administrative expenses 9,827,804 3,628,652 9,019,872
Research and development expenses -- -- 1,092,316
Reversal of warranty, maintenance &
commission accruals -- (7,151,393) --
Non cash compensation expense 1,005,232 -- --
Provision for doubtful accounts -- 28,648 --
Special charges 2,156,205 521,590 400,024
Amortization of intangibles 912,553 74,981 --
------------ ------------ ------------
18,831,291 (1,379,719) 26,049,283
------------ ------------ ------------
Operating income (loss) (11,739,631) 2,338,326 (7,232,321)
Other:
Interest expense (4,602,183) (83,029) (11,954)
Interest income 109,001 77,682 53,465
Other income (expense) (19,386) 11,226 10,179
------------ ------------ ------------
Net income (loss) (16,252,199) 2,344,205 (7,180,631)
Cumulative dividend on preferred stock (120,000) (30,667) --
------------ ------------ ------------
Net income (loss) available to common stockholders $(16,372,199) $ 2,313,538 $ (7,180,631)
============ ============ ============
Basic net income (loss) per common share $ (1.71) $ 0.97 $ (6.80)
============ ============ ============
Weighted average number of shares outstanding 9,600,322 2,387,223 1,055,745
============ ============ ============
Diluted net income (loss) per common share $ (1.71) $ 0.13 $ (6.80)
============ ============ ============
Weighted average number of common and
dilutive shares outstanding 9,600,322 18,543,707 1,055,745
============ ============ ============
</TABLE>
See accompanying notes to consolidated financial statements.
F-4
<PAGE>
THE NETWORK CONNECTION, INC.
STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
TRANSITION
YEAR ENDED PERIOD ENDED YEAR ENDED
JUNE 30, JUNE 30, OCTOBER 31,
2000 1999 1998
------------ ----------- -----------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss) $(16,252,199) $ 2,313,538 $(7,180,631)
Adjustments to reconcile net income (loss) to net cash:
Depreciation and amortization 1,458,038 342,544 1,205,361
Change in inventory valuation -- (892,010) --
Special charges 2,156,205 521,590 400,024
Non cash interest 4,336,743 -- --
Reversal of warranty, maintenance and commission accruals -- (7,151,393) --
Loss on sale of assets held for sale 37,893 -- --
Loss on disposal of assets 44,300 -- --
Non cash compensation expense 1,005,232 -- --
Changes in net assets and liabilities, net of effect of Transaction:
Decrease (increase) in accounts receivable 19,841 (482,344) 4,523,470
Decrease (increase) in inventories (957,625) 1,897,437 5,105,334
Decrease (increase) in prepaid expenses (24,955) (116,717) 47,428
Increase in due from affiliate (73,607) -- --
Decrease in other current assets 38,141 78,134 247,549
Increase in other assets (31,250) -- (411,042)
(Decrease) increase in accounts payable 2,817,583 (1,449,333) (4,933,431)
(Decrease) increase in accrued liabilities 153,983 702,559 (1,758,210)
(Decrease) increase in deferred revenue 374,234 1,138,048 (1,930,882)
Increase in accrued product warranties 141,796 -- 758,321
------------ ----------- -----------
Net cash used in operating activities $ (4,755,647) $(3,097,947) $(3,926,709)
------------ ----------- -----------
Cash flows from investing activities:
Purchases of investment securities -- (302,589) --
Sale of investment securities 303,115 -- --
Purchases of property and equipment (3,479,808) (18,243) (36,008)
Proceeds from sale of equipment 3,590 -- 3,620
Proceeds from sale of assets held for sale 762,107 -- --
Cash acquired in Transaction -- 23,997 --
Increase in restricted cash (29,236) (9,177) (437,502)
Repayments on notes receivable 42,381 -- --
------------ ----------- -----------
Net cash used in investing activities $ (2,397,851) $ (306,012) $ (469,890)
------------ ----------- -----------
Cash flows from financing activities:
Payments on notes payable (787,840) (58,450) (80,753)
Borrowings under revolving credit facility 4,200,000 -- --
Advances from related parties 1,138,044 -- --
Advances under equity purchase agreement 500,000 -- --
Re-purchase of outstanding warrants (296,040) -- --
Advances from parent -- 805,616 --
Capital contribution -- 5,391,951 4,427,544
Employee stock option exercises 236,077 2,000 --
------------ ----------- -----------
Net cash provided by financing activities $ 4,990,241 $ 6,141,117 $ 4,346,791
------------ ----------- -----------
Effect of exchange rate on cash and cash equivalents (8,528) -- --
------------ ----------- -----------
Net increase (decrease) in cash and cash equivalents (2,171,785) 2,737,158 (49,808)
Cash and cash equivalents at beginning of year 2,751,506 14,348 64,156
------------ ----------- -----------
Cash and cash equivalents at end of year $ 579,721 $ 2,751,506 $ 14,348
============ =========== ===========
</TABLE>
See accompanying notes to financial statements.
F-5
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIENCY)
AND COMPREHENSIVE INCOME
Year Ended June 30, 2000, Transition Period Ended June 30, 1999
and Year Ended October 31, 1998
<TABLE>
<CAPTION>
SERIES B SERIES C SERIES D COMMON PAID-IN
PREFERRED PREFERRED PREFERRED STOCK CAPITAL
--------- --------- --------- ----- -------
<S> <C> <C> <C> <C> <C>
Balance as of October 31, 1997 $ -- $ -- $ -- $ -- $ --
Contributed capital -- -- -- -- --
Net loss -- -- -- -- --
---- ---- ------- ------- ------------
Balance as of October 31, 1998 $ -- $ -- $ -- $ -- $ --
Contributed capital -- -- -- -- --
Contribution of advances to capital -- -- -- -- 85,010,410
Issuance of stock 15 8 24,954 6,338 3,304,536
Exercise of stock options -- -- -- 1 1,999
Comprehensive income (loss):
Unrealized loss on available for sale securities -- -- -- -- --
Net income -- -- -- -- --
Total comprehensive income -- -- -- -- --
---- ---- ------- ------- ------------
Balance as of June 30, 1999 $ 15 $ 8 $24,954 $ 6,339 $ 88,316,945
Issuance of stock for services -- -- -- 106 312,970
Exercise of stock options -- -- -- 112 235,965
Dividends payable to affiliate -- -- -- -- (140,000)
Conversion of Promissory Note -- -- -- 4,802 4,471,246
Conversion of Series C Stock -- (8) -- 886 (878)
Partial conversion of Facility -- -- -- 1,233 1,848,766
Conversion of note payable -- -- -- 200 399,800
Purchase of outstanding warrants -- -- -- -- (296,036)
Advance under equity purchase agreement -- -- -- -- 447,544
Net issuance of commitment shares associated
with equity purchase agreement -- -- -- 315 605,818
Beneficial conversion on Facility -- -- -- -- 4,200,000
Cashless exercise of outstanding warrants -- -- -- 467 (467)
Non-cash compensation and issuance of warrants for services -- -- -- -- 853,910
Issuance of warrants to related party in connection
with financing -- -- -- -- 797,668
Comprehensive loss:
Loss on foreign currency translation -- -- -- --
Change in unrealized loss on avilable for sale securities -- -- -- --
Net loss -- -- -- --
Total comprehensive loss -- -- -- -- --
---- ---- ------- ------- ------------
Balance as of June 30, 2000 $ 15 $ -- $24,954 $14,460 $102,053,251
==== ==== ======= ======= ============
ACCUMULATED OTHER
ADDITIONAL CONTRIBUTED ACCUMULATED TOTAL
CAPITAL IN EXCESS COMPREHENSIVE (DEFICIT) STOCKHOLDERS'
OF PAR VALUE INCOME INCOME EQUITY (DEFICIENCY)
------------ ------ ------ -------------------
Balance as of October 31, 1997 $ 75,190,915 $ -- $(78,193,448) $ (3,002,533)
Contributed capital 4,427,544 -- -- 4,427,544
Net loss -- -- (7,180,631) (7,180,631)
------------ -------- ------------ ------------
Balance as of October 31, 1998 $ 79,618,459 $ -- $(85,374,079) $ (5,755,620)
Contributed capital 5,391,951 -- -- 5,391,951
Contribution of advances to capital (85,010,410) -- -- --
Issuance of stock -- -- -- 3,335,851
Exercise of stock options -- -- -- 2,000
Comprehensive income (loss):
Unrealized loss on available for sale securities -- (526) -- --
Net income -- -- 2,313,538 --
Total comprehensive income -- -- -- 2,313,012
------------ -------- ------------ ------------
Balance as of June 30, 1999 $ -- $ (526) $(83,060,541) $ 5,287,194
Issuance of stock for services -- -- -- 313,076
Exercise of stock options -- -- -- 236,077
Dividends payable to affiliate -- -- -- (140,000)
Conversion of Promissory Note -- -- -- 4,476,048
Conversion of Series C Stock -- -- -- --
Partial conversion of Facility -- -- -- 1,849,999
Conversion of note payable -- -- -- 400,000
Purchase of outstanding warrants -- -- -- (296,036)
Advance under equity purchase agreement -- -- -- 447,544
Net issuance of commitment shares associated
with equity purchase agreement -- -- -- 606,133
Beneficial conversion on Facility -- -- -- 4,200,000
Cashless exercise of outstanding warrants -- -- -- --
Non-cash compensation and issuance of warrants for services -- -- -- 853,910
Issuance of warrants to related party in connection
with financing -- -- -- 797,668
Comprehensive loss:
Loss on foreign currency translation -- (11,521) -- --
Change in unrealized loss on avilable for sale securities -- 526 -- --
Net loss -- -- (16,252,199) --
Total comprehensive loss -- -- -- (16,263,194)
------------ -------- ------------ ------------
Balance as of June 30, 2000 $ -- $(11,521) $(99,312,740) $ 2,768,419
============ ======== ============ ============
</TABLE>
See accompanying notes to consolidated financial statements.
F-6
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND PRACTICES
(a) DESCRIPTION OF BUSINESS
The Network Connection, Inc. and Subsidiary (the "Company" or "TNCi") was
incorporated on December 30, 1986. The Company designs, manufactures, installs
and maintains advanced, high-end, high-performance computer servers and
interactive, broad-band information and entertainment systems, and procures and
provides the content available through the systems. These all-digital systems
deliver an on-demand multimedia experience via high-speed, high-performance
Internet Protocol (IP) networks. These systems are designed to provide users
access to information, entertainment and a wide array of service options, such
as shopping for goods and services, computer games, access to the World Wide Web
and on-line gambling where permitted by applicable law. The service options
available are customized for each installation and generally vary depending on
the environment in which each system is installed. Our targeted markets for
these systems are hotels and time-share properties, cruise ships, educational
institutions and corporate training, and passenger trains.
(b) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of The Network
Connection, Inc. and its wholly-owned UK subsidiary, TNCi UK Limited. All
significant intercompany accounts and transactions have been eliminated in
consolidation.
(c) BASIS OF PRESENTATION
On May 18, 1999, Global Technologies, Ltd. (formerly known as Interactive
Flight Technologies, Inc.) ("Global") received from the Company 1,055,745 shares
of its common stock and 2,495,400 shares of its Series D Convertible Preferred
Stock in exchange for $4,250,000 in cash and substantially all the assets and
certain liabilities of Global's Interactive Entertainment Division ("IED"), as
defined in the Asset Purchase and Sale Agreement dated April 30, 1999, as
amended (the "Transaction"). The Transaction has been accounted for as a reverse
merger whereby, for accounting purposes, Global is considered the accounting
acquiror, and although the legal capital structure carries forward, and the
Company is treated as the successor to the historical operations of IED.
Accordingly, the historical financial statements of the Company, which
previously have been reported to the Securities and Exchange Commission ("SEC")
on Forms 10-KSB, 10-QSB, among others, as of and for all periods through March
31, 1999, will be replaced with those of IED.
The Company will continue to file as a SEC registrant and continue to
report under the name The Network Connection, Inc. The financial statements as
of and for the year ended October 31, 1998 reflect the historical results of
Global's IED as previously included in Global's consolidated financial
statements. Included in the results of operations for the eight months ended
June 30, 1999 are the historical results of Global's IED through April 30, 1999,
and the results of the post Transaction company for the two months ended June
30, 1999. The Transaction date for accounting purposes is May 1, 1999.
Contributed capital reflects the cash consideration paid by Global to the
Company in the Transaction in addition to funding of IED historical operations.
Global will continue to report as a separate SEC registrant, owning the shares
of the Company as described above. As of June 30, 1999, the Company is a
majority owned subsidiary of Global whose ownership, through a combination of
the Transaction described above and Global's purchase of Series B 8 % preferred
stock of the Company and 110,000 shares of the Company's common stock from third
party investors, approximates 78% of the Company on an if-converted common stock
basis. (See Note 17). As of June 30, 2000, Global's ownership in the Company
increased to 79% as a result of continued investment on the part of Global,
offset by additional third party investment and exercise of warrants and stock
options. The historical financial statements of the Company up to the date of
the Transaction as previously reported will no longer be included in future
filings of the Company.
F-7
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
(d) USE OF ESTIMATES
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements. Additionally, such estimates and assumptions affect the reported
amounts of revenue and expenses during the reporting period. Actual results
could differ from those estimates.
(e) CHANGE IN FISCAL YEAR-END
As of June 30, 1999, the Company changed its fiscal year-end from December
31 to June 30. The Transition Period resulting from the change in fiscal
year-end is measured from IED's former fiscal year-end of October 31.
Accordingly, the eight-month period resulting from this change, November 1, 1998
through June 30, 1999, is referred to as the "Transition Period."
(f) CASH EQUIVALENTS
The Company considers all highly liquid investments with original
maturities at the date of purchase of three months or less to be cash
equivalents.
(g) INVESTMENT SECURITIES
Investment securities consisted of debt securities with a maturity greater
than three months at the time of purchase. In accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain Investments in
Debt and Equity Securities" ("SFAS No. 115") the debt securities are classified
as available-for-sale and carried at fair value, based on quoted market prices.
The net unrealized gains or losses on these investments are reported in
stockholders' equity. The specific identification method is used to compute the
realized gains and losses on the debt securities.
(h) INVENTORIES
Inventories consisting principally of entertainment network components are
stated at the lower of cost (first-in, first-out method) or market. As of June
30, 1999, inventories consisted of $1.4 million of finished goods.
(i) INTANGIBLES
Intangibles consist of goodwill and trademarks. Goodwill represents the
excess of the purchase price over the fair value of the net assets acquired and
is amortized over five years using the straight-line method. Effective May 1,
2000, the Company revised its estimate of the remaining useful life of its
goodwill from ten years to five years as a result of economic events which
occurred during the period. (See Note 22(e)). Goodwill amortization expense was
$896,287, $73,986 and $0 in the year ended June 30, 2000, the Transition period
ended June 30, 1999 and the year ended October 31, 1998, respectively. Had the
Company assumed a five-year life for goodwill amortization at the Transition
date, additional expense of approximately $593,000 (unaudited) would have been
recorded for the year-ended June 30, 2000, and approximately $712,000
(unaudited) for each of the remaining years.
Trademarks are stated at fair market value at the date of acquisition and
are amortized over ten years using the straight-line method.
The Company continually evaluates whether events and circumstances have
occurred that indicate the remaining estimated useful lives of intangibles may
warrant revision or that the remaining balances may not be recoverable. When
factors indicate that the assets should be evaluated for possible impairment,
the Company uses an estimate of the undiscounted net cash flows over the
remaining life of the assets in measuring whether the asset is recoverable. In
cases where undiscounted expected future cash flows are less than the carrying
value, an impairment loss is recognized to reduce the carrying value of the
intangible to its estimated fair value.
F-8
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
(j) PROPERTY AND EQUIPMENT
Property and equipment are stated at the lower of cost or net realizable
value. Depreciation and amortization expense is calculated using the
straight-line method over the estimated useful lives of the assets ranging from
three to seven years. Leasehold improvements are amortized using the
straight-line method over the shorter of the underlying lease term or asset
life. Guest pay interactive systems consist of equipment and related costs of
installation. Construction in progress consists of purchased and manufactured
parts of partially installed guest pay interactive systems.
(k) REVENUE RECOGNITION
The Company's revenue derived from sales and installation of equipment is
recognized upon installation and acceptance by the customer. Fees derived from
servicing installed systems are recognized when earned, according to the terms
of the service contract. Revenue pursuant to contracts that provide for revenue
sharing with customers and/or others is recognized in the period the services
are purchased by the systems' end users (i.e., a hotel guest). Revenue earned
pursuant to extended warranty agreements is recognized ratably over the warranty
period.
(l) DEFERRED REVENUE
Deferred revenue represents cash received on advance billings of equipment
sales as allowed under installation and extended warranty contracts.
(m) RESEARCH AND DEVELOPMENT
Research and development costs are expensed as incurred except for
development costs required by a customer contract. Development costs incurred
pursuant to contractual obligations are allocated to deliverable units. These
development costs are expensed as cost of equipment sales upon installation of
the complete product and acceptance by the customer.
(n) WARRANTY COSTS
The Company provides, by a current charge to income, an amount it estimates
will be needed to cover future warranty obligations for products sold with an
initial warranty period. Revenue and expenses under extended warranty agreements
are recognized ratably over the term of the extended warranty.
(o) IMPAIRMENT OF LONG-LIVED ASSETS
The Company evaluates the potential impairment of long-lived assets in
accordance with Statement of Financial Accounting Standards No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
Of". In cases where undiscounted expected future cash flows are less than the
carrying value, an impairment loss is recognized to reduce the carrying value of
the asset to its estimated fair value.
(p) INCOME TAXES
Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.
(q) NET INCOME (LOSS) PER SHARE
Basic net income (loss) per share is computed by dividing net income (loss)
available to common stockholders, by the weighted average number of common
F-9
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
shares outstanding for the period. Diluted net income (loss) per share reflects
the potential dilution that could occur if securities or other contracts to
issue common stock were exercised or converted into common stock or resulted in
the issuance of common stock that then shared in the net income (loss) of the
Company.
(r) STOCK-BASED COMPENSATION
In accordance with the provisions of Accounting Principals Board Opinion
No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), the Company
measures stock-based compensation expense as the excess of the market price at
the grant date over the amount the employee must pay for the stock. The
Company's policy is to generally grant stock options at fair market value at the
date of grant; accordingly, no compensation expense is recognized. Statement of
Financial Accounting Standards (SFAS No. 123 "Accounting for Stock Based
Compensation") established accounting and disclosure requirements using a fair
value based method of accounting for stock based employee compensation plans. As
permitted, the Company has elected to adopt the pro forma disclosure provisions
only of SFAS No. 123.
(s) RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivatives and Similar Financial Instruments and for Hedging
Activities", to establish accounting and reporting standards for derivative
instruments and for hedging activities. It requires that an entity recognize all
derivatives as either assets or liabilities on the balance sheet and measure
those instruments at fair value. This new standard, as amended by related SFAS
Nos. 137 and 138, will be effective for the Company for its fiscal year ending
June 30, 2001. We are currently evaluating the impact of SFAS No. 133.
In March 2000, the Financial Accounting Standards Board issued FASB
Interpretation No. 44, Accounting for Certain Transactions Involving Stock
Compensation (an interpretation of APB 25). This interpretation clarifies the
application of APB No. 25 by clarifying the definition of an employee, the
determination of non-compensatory plans and the effect of modifications to stock
options. This interpretation is effective July 1, 2000 and is not expected to
have a material effect on the Company's consolidated financial statements.
(t) FOREIGN CURRENCY TRANSLATION
The consolidated financial statements of the Company's United Kingdom
subsidiary are translated into U.S. dollars in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 52, "Foreign Currency Translation".
Assets and liabilities of the subsidiary are translated into U.S. dollars at
current exchange rates. Income and expense items are translated at the average
exchange rate for the year. The resulting translation adjustments are recorded
directly as a separate component of stockholders' equity. All transaction gains
or losses are recorded in the statement of operations.
(u) RECLASSIFICATIONS
Certain reclassifications have been made to the 1999 consolidated financial
statements to conform to the 2000 presentation.
(v) COMPREHENSIVE INCOME
The Company reports comprehensive income and its components in its full set
of financial statements in accordance with SFAS No. 130, "Reporting
Comprehensive Income". Comprehensive income consists of net income and foreign
currency translations, net of taxes and is presented in the consolidated
statement of stockholders, equity and comprehensive income; it does not affect
the Company's financial position or results of operations.
(w) FAIR VALUE OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107 "Disclosure about Fair
Value of Financial Instruments" requires that the Company disclose estimated
fair values for its financial instruments. The following summary presents a
description of the methodologies and assumptions used to determine such amounts.
Fair value estimates are made at a specific point in time and are based on
relevant market information and information about the financial instrument; they
are subjective in nature and involve uncertainties, matters of judgment and,
therefore, cannot be determined with precision. These estimates do not reflect
any premium or discount that could result from offering for sale, at one time,
the Company's entire holdings of a particular instrument. Changes in assumptions
could significantly affect these estimates.
Since the fair value is estimated as of June 30, 2000, the amounts that
will actually be realized or paid at settlement or maturity of the instruments
could be significantly different.
The carrying amount of cash, cash equivalents and restricted cash
approximates fair value because their maturity is generally less than three
months. The carrying amount of accounts receivable, accounts payable and accrued
liabilities approximate fair value as they are expected to be collected or paid
within ninety days of year-end. The fair value of notes receivable and notes
payable approximate the terms in the marketplace at which they could be
replaced. Therefore, the fair value approximates the carrying value of these
financial instruments.
(2) FINANCIAL CONDITION AND LIQUIDITY
The Company's consolidated financial statements are prepared using
generally accepted accounting principles applicable to a going concern which
F-10
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
contemplate the realization of assets and liquidation of liabilities in the
normal course of business. The Company, which has incurred net losses from
operations for two of the last three periods, has an accumulated deficit at June
30, 2000 as a result of efforts to build its customer base and develop its
operations. Management believes that our current cash balances, the $5 million
credit facility with Global Technologies (of which approximately $2.7 million
remains available as of September 29, 2000), and currently available external
sources of financing will not be sufficient to meet our currently anticipated
cash requirements for operations for the next 12 months. A substantial portion
of the Company's accounts payable are past due and many suppliers have imposed
cash on delivery terms. The Company is in discussions with private equity
sources which, if transactions are consumated, together with the Global
Technologies credit facility and currently available external sources of
financing, should provide sufficient short-term funding. Our inability to draw
on the credit facility with Global Technologies, to obtain funds pursuant to the
currently available external sources of financing, or not complete certain
private placement transactions, would have a material adverse effect on our
operating results, financial condition and ability to continue as a going
concern.
Global Technologies does not currently have sufficient cash for us to
borrow under the credit facility and no assurance can be given that currently
available external sources of financing will have the resources necessary to
meet its commitments as we draw down from time to time pursuant to our private
equity line, or that other financings will be consumated. Additionally, any
increases in the Company's growth rate, shortfalls in anticipated revenues,
increases in anticipated expenses, or significant acquisition or expansion
opportunities could have a material adverse effect on the Company's liquidity
and capital resources and would require the Company to raise additional capital
from public or private equity or debt sources in order to finance operating
losses, anticipated growth, and contemplated capital expenditures and
expansions.
The Company has significant expansion plans which it intends to fund with
the facilities discussed above; however, if there is any delay in the
anticipated closing of these facilities or any shortfall, the Company will not
engage in such expansion until adequate capital sources have been arranged. If
such sources of financing are insufficient or unavailable, the Company will be
required to modify its growth and operating plans or scale back operations to
the extent of unanticipated opportunities, such as acquisitions of complementary
businesses or the development of new products, or otherwise respond to
unanticipated competitive pressures. There can be no assurance that the Company
will be able to raise any such capital on terms acceptable to the Company or at
all.
The Company expects to continue to focus on developing and expanding its
enhanced broadband information and entertainment systems while continuing to
expand its current operation's market penetration. Accordingly, the Company
expects that its capital expenditures and cost of revenues and depreciation and
amortization expenses will continue to increase significantly, all of which
could have a negative impact on short-term operating results. In addition, the
Company may change its strategy to respond to a changing competitive
environment. There can be no assurance that growth in the Company's revenue or
market penetration will continue, that its expansion efforts will be profitable,
or that the Company will be able to achieve or sustain profitability or positive
cash flow. Further, the Company will require substantial financing to continue
as a going concern, accomplish any significant acquisition or merger
transaction, and provide for working capital to operate its current and proposed
expanded operations until profitability is achieved, if ever.
(3) ACQUISITION
The Transaction has been accounted for by the purchase method of accounting
and, accordingly, the purchase price has been allocated to the assets acquired
and the liabilities assumed based upon estimated fair values at the date of
acquisition as follows:
F-11
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
Purchase Price:
Cash $ 4,250,000
Net liabilities of IED contributed (4,012,430)
-----------
Total $ 237,570
===========
Assets acquired and liabilities assumed:
Historical book value of net liabilities $(2,457,723)
Fair value adjustments:
Inventory (1,280,847)
Property and equipment (1,246,145)
Other assets (430,567)
Liabilities (672,506)
-----------
Total fair value of liabilities assumed $(6,087,788)
Excess of fair value of TNCi Series B Preferred Stock
and Series C Preferred Stock over its recorded value $(1,501,000)
Purchase of Common Stock of TNCi (254,658)
===========
Excess of purchase price over fair value of net
liabilities assumed (goodwill) $ 7,605,876
===========
The excess of fair value of TNC Series B Preferred Stock and Series C
Preferred Stock is the result of Global's acquisition of such shares based on
the fair value of the Global Series A Preferred Stock amounting to $4,080,000,
less $980,000 (net of $50,000 of legal fees) cash received and the historical
value of $1,549,000 of the Series B Preferred Stock.
Purchase of 110,000 shares of Common Stock of TNCi from a third party was
valued based on the cash consideration paid by Global for the shares.
On May 9, 2000, pursuant to the indemnification provisions of the Asset
Purchase and Sale Agreement, Global notified the Company of several violations
of representation and warranties contained in the Agreement, including
undisclosed liabilities. Accordingly, previously recognized fixed assets and
unrecorded liabilities were recorded with an adjustment to goodwill of $490,702.
The Company will issue an additional 270,081 shares to Global in consideration
of the indemnification provisions.
(4) RESTRICTED CASH
At June 30, 2000 and 1999, the Company held restricted cash of $475,915 and
$446,679, respectively, in a trust fund for payments which may be required under
a severance agreement with one former executive of Global. (See Note 17.)
(5) INVESTMENT SECURITIES
A summary of investment securities by major security type at June 30, 1999
follows:
F-12
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
GROSS GROSS
UNREALIZED UNREALIZED
AMORTIZED HOLDING HOLDING FAIR
COST GAINS LOSSES VALUE
---- ----- ------ -----
Available-for-sale:
Corporate debt securities $303,115 $167 $(693) $302,589
======== ==== ===== ========
(6) ASSETS HELD FOR SALE
In connection with the acquisition of TNCi, the Company relocated corporate
offices and production capabilities of TNCi to its Phoenix, Arizona offices.
Accordingly, as of June 30, 1999, certain assets were recorded at their net
realizable value and classified as assets held for sale. In September 1999, TNCi
sold one of its two buildings in Alpharetta, Georgia. The net proceeds of
approximately $390,000 from the sale, plus additional cash of approximately
$80,000, was used by the Company to repay a note payable due April 2001, in the
principal amount of $470,000. The sale of the second building occurred in
November 1999. The net proceeds of approximately $367,000 from the sale were
used to retire a note payable due 2009 in the principal amount of $220,508.
(7) PROPERTY AND EQUIPMENT
A summary of property and equipment follows:
JUNE 30, JUNE 30,
2000 1999
----------- -----------
Leasehold improvements $ 199,143 $ 24,117
Purchased software 188,476 149,703
Furniture 160,648 163,609
Equipment 1,831,563 1,684,180
Guest pay interactive systems:
Installed 467,885 --
Construction in progress:
System components 967,215 --
Work in progress 1,009,907 --
----------- -----------
4,824,837 2,021,609
Less: accumulated depreciation
and amortization (1,014,188) (683,029)
----------- -----------
Property and equipment, net $ 3,810,649 $ 1,338,580
=========== ===========
(8) INTANGIBLES
A summary of intangibles follows:
JUNE 30, JUNE 30,
2000 1999
----------- -----------
Goodwill $ 7,605,876 $ 7,115,174
Trademarks 79,613 79,613
----------- -----------
7,685,489 7,194,787
Accumulated amortization (987,534) (74,981)
----------- -----------
$ 6,697,955 $ 7,119,806
=========== ===========
F-13
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
(9) ACCRUED LIABILITIES
A summary of accrued liabilities follows:
JUNE 30, JUNE 30,
2000 1999
---------- ----------
Due to related parties (See Note 17) $1,419,716 $1,891,123
Other accrued expenses 1,505,081 318,559
---------- ----------
Accrued liabilities $2,924,797 $2,209,682
========== ==========
(10) NOTES PAYABLE TO RELATED PARTIES
In May and June 2000, The Gross Charitable Unit Trust and The Gross
Charitable Annuity Trust (together the "Trusts"), advanced a total of $800,000
to the Company for working capital purposes. An additional $250,000 was advanced
to the Company in July 2000. On September 12, 2000, the advances were converted
into two promissory notes, each in the amount of $525,000, issued to each Trust
by the Company. The notes mature on December 31, 2000 and bear interest at 9%.
The Trusts are controlled by the Company's Chairman and Chief Executive Officer,
Irwin L. Gross. (See Note 17 - Related Party Transactions and Note 22 (c).)
As of June 30, 1999, the Company had notes payable in the amount of $68,836
to related parties with interest payable at approximately 5% per annum. These
notes became due and payable upon achievement of certain operational goals which
were achieved during the fiscal year ended June 30, 2000, and accordingly paid
in full.
On August 24, 1999, the Board of Directors of Global approved a $5 million
secured revolving credit facility by and between Global and the Company (the
"Facility"). The Facility provides that the Company may borrow up to $5 million
for working capital and general corporate purposes at the prime rate of interest
(9.5% at June 30, 2000) plus 3%. The Facility matures in September 2001. The
Company paid an origination fee of $50,000 to Global and will pay an unused line
fee of 0.5% per annum. The Facility is secured by all of the assets of the
Company and is convertible, at any time at Global's option, into shares of the
Company's Series C Stock or Common Stock at a price equal to the lesser of 66.7%
of the closing bid price for the trading day immediately preceding the
Conversion Date, $1.50 per share or any lesser amount at which Common Stock has
been issued to third parties. Pursuant to Nasdaq rules, Global may not convert
borrowings under the Facility into shares of Common Stock in excess of 19.99% of
the number of shares of Common Stock outstanding on August 24, 1999 without
shareholder approval. On June 29, 2000, Global exercised its right to convert
$1,850,000 of the balance outstanding under the Facility into 1,233,333 shares
of the Company's Common Stock. As of June 30, 2000, $2,350,000 was outstanding
under the Facility.
The Company's revolving credit facility is considered a convertible debt
security with a nondetachable conversion feature. The conversion rate of the
Facility is measured each time the Company borrows or repays amounts under the
Facility ("Commitment Date"). If the market price of the Company's common stock
at the Commitment Date is greater than the Conversion Price, the advance is
considered to be in-the-money and is considered to have an embedded beneficial
conversion feature.
EITF 98-5, "Accounting for Convertible Securities with Beneficial
Conversion Features or Contingently Adjustable Conversion Ratios" requires that
embedded beneficial conversion features present in convertible securities should
be valued separately.
The Company's borrowings under the Facility during the year ended June 30,
2000 and related beneficial conversion features resulted in a charge to earnings
of $4.2 million of which $1,080,000 relates to the quarter ended March 31, 2000,
and $3.1 million relates to the quarter ended June 30, 2000, and is recorded in
interest expense. Had the Company identified this beneficial conversion feature
of $1,080,000 (unaudited) as of March 31, 2000, the net loss of the Company for
the three-month period ended March 31, 2000 would have increased from $(3.0)
million (unaudited) to $(4.0) million (unaudited) and basic and diluted net loss
per share would have increased from $(.24) (unaudited) to $(.33) (unaudited).
The net loss of the Company for the nine-month period ended March 31, 2000 would
have increased from $(4.4)
F-14
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
million (unaudited) to $(5.5) million (unaudited) and basic and diluted net loss
per share increased from $(.52) (unaudited) to $(.65) (unaudited).
Prior to the Transaction, the Company entered into a secured promissory
note with Global in the principal amount of $750,000, bearing interest at a rate
of 9.5% per annum, and a related security agreement granting Global a security
interest in its assets (the "Promissory Note"). The Promissory Note was
convertible into shares of the Company's Series C Stock on the same terms and
conditions as the Facility described above, at the discretion of Global. Global
has also advanced approximately $898,000 to the Company in the form of
intercompany advances. As of June 30, 1999, $1,647,692 was outstanding under
these arrangements.
(11) NOTES PAYABLE
Notes payable consists of the following:
<TABLE>
<CAPTION>
JUNE 30, JUNE 30,
2000 1999
---------- ----------
<S> <C> <C>
Series A, D & E Notes (see below) -- 2,386,048
Note payable due September 5, 1999, interest at 7%, convertible to Common
Stock at the option of the Company (see below) -- 400,000
Note payable due in varying installments through 2009, interest at prime
(8.25% at June 30, 1999) plus 2%, collateralized by certain commercial
property and personally guaranteed by two shareholders (see below) -- 220,508
Note payable due in varying installments through December 2000, interest at
6.9%, collateralized by a vehicle 4,744 10,308
Note payable due and payable April 19, 2001, interest 16% payable monthly,
collateralized by certain commercial property (see below) -- 470,000
Note payable due in varying installments through 2000, interest at 11%,
collateralized by a vehicle -- 4,572
---------- ----------
4,744 3,491,436
Less current portion 4,744 24,391
---------- ----------
$ 0 $3,467,045
========== ==========
</TABLE>
(a) SERIES NOTES
The Series A, D and E Notes ("Series Notes") were issued by the Company in
1998 prior to the Transaction. The Series Notes all had original maturities of
approximately 135 days with interest at approximately 7% to 8% per annum. The
Company could choose to repay such Notes in cash subject to a payment charge
equal to approximately 7% of the face amount of the Note or the Company could
elect to convert the Series Notes into preferred stock of the Company which is
convertible into common stock. In July and August 1999, Global purchased all of
the Series Notes from the holders of such notes. Concurrent with such purchase
by Global, the Company executed several allonges to the Promissory Note which
cancelled such Series Notes and rolled the principal balance, plus accrued but
unpaid interest, penalties and redemption premiums on the Series Notes into the
principal balance of the Promissory Note. Subsequent to May 18, 1999, Global had
also advanced working capital to the Company in the form of intercompany
advances. In August 1999, the Company executed an allonge to the Promissory Note
which rolled the intercompany advances into the principal balance of the
Promissory Note and granted Global the ability to convert the Promissory Note
directly into shares of the Company's Common Stock, without first converting to
Series C Stock, as an administrative convenience.
F-15
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
On August 24, 1999, the Board of Directors of Global approved the
conversion of the Promissory Note into shares of the Company's Common Stock.
Such conversion, to the extent it exceeded approximately one million shares of
the Company's Common Stock on August 24, 1999, was contingent upon receiving
shareholder approval to increase the authorized share capital of the Company.
This increase in authorized share capital was subsequently approved at the
September 17, 1999 Special Meeting of the Company's shareholders. Accordingly,
in December 1999, the Company issued to Global 4,802,377 shares of its Common
Stock based on the conversion date of August 24, 1999.
(b) OTHER NOTES PAYABLE
In September 1999, the Company sold one of its two buildings in Alpharetta,
Georgia. The net proceeds of approximately $390,000 from the sale, plus
additional cash of approximately $80,000, was used by the Company to repay a
note payable due April 2001, in the principal amount of $470,000. The sale of
the second building occurred in November 1999. The net proceeds of approximately
$367,000 from the sale were used to retire the note payable due 2009 in the
principal amount of $217,000.
In October 1999, a note payable in the principle amount of $400,000 due
September 5, 1999 was converted into 200,000 shares of the Company's Common
Stock.
(12) NET INCOME (LOSS) PER SHARE
For the Transition Period, basic weighted average number of shares
outstanding includes 1,055,745 common shares held by Global for the full period
and approximately 5.3 million shares (the shares issued and outstanding prior to
the Transaction) for two months. Diluted weighted average number of shares
outstanding for the Transition Period include 1,055,745 common shares and
15,097,170 potential dilutive securities resulting from the Series D Convertible
Preferred Stock for the entire Transition Period (both issued to Global in
connection with the Transaction); plus 5,278,737 common shares outstanding prior
to the merger, and 1,133,120 common stock equivalents related to the Convertible
Promissory Note, Series A, D and E Convertible Notes, Series B 8% Convertible
Preferred Stock, Series C 8% Convertible Preferred Stock and options each
weighted for the two months ended June 30, 1999.
Basic and diluted weighted average number of shares outstanding for the
year ended October 31, 1998 included 1,055,745 shares of the Company's common
stock, representing 100% of the Company's capital stock which was all owned by
Global. No effect was given to common stock equivalents in either year in the
computation of diluted loss per share for the years ended June 30, 2000 and
October 31, 1998 as their effect would have been anti-dilutive.
F-16
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
<TABLE>
<CAPTION>
TRANSITION YEAR ENDED
YEAR ENDED PERIOD ENDED OCTOBER 31,
JUNE 30, 2000 JUNE 30, 1999 1998
------------- ------------- ------------
<S> <C> <C> <C>
Net income (loss) $ (16,252,199) $ 2,344,205 $ (7,180,631)
Less: preferred stock dividends (120,000) (30,667) --
------------- ------------ ------------
Income (loss) available to common stockholders $ (16,372,199) $ 2,313,538 $ (7,180,631)
============= ============ ============
Basic EPS - weighted average shares outstanding 9,600,322 2,387,223 1,055,745
============= ============ ============
Basic net income (loss) per share $ (1.71) $ 0.97 $ (6.80)
============= ============ ============
Basic EPS - weighted average shares outstanding 9,600,322 2,387,223 1,055,745
Effect of dilutive securities:
Stock Purchase Options - common stock -- 82,033 --
Convertible preferred stock -- 15,570,814 --
Convertible debt -- 503,638 --
------------- ------------ ------------
Dilutive EPS - weighted average shares outstanding 9,600,322 18,543,708 1,055,745
Net income (loss) $ (16,372,199) $ 2,344,205 $ (7,180,631)
------------- ------------ ------------
Diluted net income (loss) per share $ (1.71) $ 0.13 $ (6.80)
============= ============ ============
Common stock equivalents not included in dilutive EPS
since antidilutive
- Convertible preferred stock 16,273,641 -- 15,097,170
============= ============ ============
- Convertible debt 1,566,667 -- --
============= ============ ============
- Stock options and warrants 4,026,348 -- --
============= ============ ============
</TABLE>
(13) STOCK OPTION PLANS
Under the Company's 1994 Employee Stock Option Plan (the "Plan"), as
amended, the Company has reserved an aggregate of 1,200,000 shares of Common
Stock for issuance under the Plan. Options granted under the Plan are for
periods not to exceed ten years. Under the Plan, incentive and non-qualified
stock options may be granted. All option grants under the Plan are subject to
the terms and conditions established by the Plan and the Stock Option Committee
of the Board of Directors. Options must be granted at not less than 100% of fair
value for incentive options and not less than 85% of fair value of non-qualified
options of the stock as of the date of grant and generally are exerciseable in
increments of 25% each year subject to continued employment with the Company.
Options generally expire five to ten years from the date of grant. Options
canceled represent the unexercised options of former employees, returned to the
option pool in accordance with the terms of the Plan upon departure from the
Company. The Board of Directors may terminate the Plan at any time at their
discretion. During the year ended June 30, 2000, 687,500 stock options with up
to a four-year vesting period were granted at exercise prices ranging from $2.00
to $11.50.
On August 16, 1995, the Company adopted the 1995 Stock Option Plan For
Non-Employee Directors (the "Directors Plan") and reserved 100,000 shares of
unissued common stock for issuance to all non-employee directors of the Company.
The Directors Plan is administered by a committee appointed by the Board of
Directors consisting of directors who are not eligible to participate in the
Directors Plan. Pursuant to the Directors Plan, directors who are not employees
of the Company may receive for their services, on the date first elected as a
member of the Board and on each anniversary thereafter, if they continue to
serve on the Board of Directors, an automatically granted option to acquire
5,000 shares of the Company's common stock at its fair market value on the date
of grant; such options become exercisable in two equal annual installments if
the individual continues at that time to serve as a director, and once
exercisable remain so until the fifth anniversary of the date of grant. Other
grants may be made at the discretion of the Board of Directors from time to
time. During fiscal 2000, there were no options granted.
F-17
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
During the year ended June 30, 2000, the Company granted options pursuant
to separate plans as described below. The total number of stock options granted
pursuant to separate plans during the year ended June 30, 2000 was 2,350,000.
In November 1999, the Compensation Committee of the Board of Directors of
the Company recommended option grants to purchase up to 500,000 shares of the
Company's Common Stock to Mr. Irwin L. Gross, Chairman and Chief Executive
Officer of the Company outside of the plans described above. Such recommendation
was accepted and approved by the Board of Directors. One quarter of these
options vested immediately and one quarter vest in equal annual installments
over three years. The remaining half vest on the sixth anniversary of the date
of grant, subject to acceleration to a three-year vesting schedule in the event
certain performance milestones are achieved. Exercise price of the options is
equal to the closing market price of the Company's Common Stock on the day of
grant. The options expire in October 2009.
On March 6, 2000, the Company granted options to purchase up to 800,000
shares of the Company's Common Stock to Mr. Robert Pringle, President and Chief
Operating Officer of the Company outside of the plans described above. One fifth
of these options vest on June 6, 2000, with the remainder vesting in four equal
annual installments beginning March 6, 2001. Exercise price of the options is
equal to the closing market price of the Company's Common Stock on the day prior
to grant, and the options expire on March 6, 2010.
On March 6, 2000, the Company granted options to purchase up to 800,000
shares of the Company's Common Stock to Dr. Jay Rosan, an Executive Vice
President of the Company outside of the plans described above. One fifth of
these options vest on June 6, 2000, with the remainder vesting in four equal
annual installments beginning March 6, 2001. Exercise price of the options is
equal to the closing market price of the Company's Common Stock on the day prior
to grant, and the options expire on March 6, 2010.
On March 6, 2000, the Company granted options to purchase up to 250,000
shares of the Company's Common Stock to Mr. Richard Genzer, Chief Technology
Officer of the Company outside of the plans described above. One fifth of these
options vest on June 6, 2000, with the remainder vesting in four equal annual
installments beginning March 6, 2001. Exercise price of the options is equal to
the closing market price of the Company's Common Stock on the day prior to
grant, and the options expire on March 6, 2010.
A summary of the aforementioned stock option activity follows:
<TABLE>
<CAPTION>
YEAR ENDED TRANSITION PERIOD ENDED
JUNE 30, 2000 JUNE 30, 1999
---------------------- ---------------------
WEIGHTED WEIGHTED
NUMBER AVERAGE NUMBER AVERAGE
OF EXERCISE OF EXERCISE
SHARES PRICE SHARES PRICE
---------- -------- -------- --------
<S> <C> <C> <C> <C>
Balance at the beginning of year 719,978 $ 3.09 676,478 $ 5.00
Granted 3,037,500 6.97 345,348 2.25
Exercised (111,823) 2.11 (20,000) 3.84
Forfeited (392,307) 4.03 (281,848) 4.75
--------- --------
Balance at the end of year 3,253,348 6.65 719,978 3.09
========= ========
Exercisable at the end of year 568,337 6.66 331,731 4.29
========= ========
Weighted-average fair value of
options granted during the year $ 6.56 $ 1.66
========= ========
</TABLE>
In accordance with the provisions of APB 25, the Company measures
stock-based compensation expense as the excess of the market price at the grant
date over the amount the employee must pay for the stock. The Company's policy
is to generally grant stock options at fair market value at the date of grant,
so no compensation expense is recognized. As permitted, the Company has elected
to adopt the disclosure provisions only of SFAS No. 123.
Had compensation cost for the Company's stock-based compensation plans been
determined consistent with SFAS No. 123, the Company's net income (loss) and net
income (loss) per share would have been reduced (increased) to the pro forma
amounts indicated below:
F-18
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
TRANSITION PERIOD
YEAR ENDED ENDED
JUNE 30, 2000 JUNE 30, 1999
------------- -------------
Net income (loss) available to
common stockholders:
As reported $ (16,372,199) $ 2,313,538
============= ===========
Pro forma $ (22,578,107) $ 2,018,009
============= ===========
Basic net income (loss) per share:
As reported $ (1.71) $ 0.97
============= ===========
Pro forma $ (2.35) $ 0.85
============= ===========
Diluted net income (loss) per share:
As reported $ (1.71) $ 0.13
============= ===========
Pro forma $ (2.35) $ 0.11
============= ===========
Pro forma net income (loss) reflect only options granted during the year
ended 2000 and the Transition Period ended 1999. There were no options granted
related to IED for the year ended October 31, 1998. Therefore, the full impact
of calculating compensation cost for stock options under SFAS No. 123 is not
reflected in the pro forma net income (loss) amount presented above because
compensation cost is reflected over the options' vesting period and compensation
cost for options granted prior to November 1995 are not considered under SFAS
No. 123.
For purposes of the SFAS No. 123 pro forma net income (loss) and net income
(loss) per share calculations, the fair value of each option grant is estimated
on the date of grant using the Black-Scholes option-pricing model with the
following weighted-average assumptions used for grants in the year ended June
30, 2000 and the Transition Period ended June 30, 1999:
TRANSITION PERIOD
YEAR ENDED ENDED
JUNE 30, 2000 JUNE 30, 1999
------------- -------------
Dividend yield 0% 0%
Expected volatility 165.87% 58.76%
Risk free interest rate 6.02% 5.67%
Expected lives (years) 5.0 10.0
The following table summarizes the status of outstanding stock options as
of June 30, 2000:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------------- -----------------------------
WEIGHTED
AVERAGE
RANGE OF NUMBER OF REMAINING WEIGHTED NUMBER OF WEIGHTED
EXERCISE OPTIONS CONTRACTUAL AVERAGE OPTIONS AVERAGE
PRICES OUTSTANDING LIFE (YEARS) EXERCISE PRICE EXERCISABLE EXERCISE PRICE
-------------- ----------- ------------ -------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
$2.00 - $ 2.25 258,848 8.20 $2.23 73,337 $2.25
2.31 - 4.97 913,000 8.93 2.90 125,000 2.31
5.13 - 5.88 92,000 9.59 5.62 -- --
6.50 - 8.72 54,500 9.60 7.70 -- --
9.00 - 11.50 1,935,000 9.67 9.04 370,000 9.00
--------- -------
Total 3,253,348 568,337
========= =======
</TABLE>
F-19
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
(14) BENEFIT PLAN
On June 1, 1999 a formal termination of the Company's 401(k) plan was
initiated. The formal termination is expected to be completed in October 2000.
The 401(k) plan of parent company Global was amended June 1, 1999 to include
employees of the Company.
Global has adopted a defined contribution benefit plan that complies with
section 401(k) of the Internal Revenue Code and provides for discretionary
company contribution. Employees who complete three months of service are
eligible to participate in the Plan. Global did not make any contributions to
the Plan for the year ended June 30, 2000, the Transition Period ended June 30,
1999, nor the year ended October 31, 1998.
(15) STOCKHOLDERS' EQUITY
PREFERRED STOCK
Series B 8% Convertible Preferred Stock ("Series B Stock"); stated value
$1,000 per share and liquidation value of 120% of stated value. The Holder of
Series B Stock is entitled to an annual cumulative dividend of $80 per share
payable quarterly in cash or Common Stock. Cumulative unpaid dividends at June
30, 2000 total $140,000. Each share of Series B Stock is convertible into Common
Stock at a price equal to the lowest of: a) 75% of the Average Price of Common
Stock, as defined, or b) 75% of the Average Price of Common Stock, as defined
calculated as if April 29, 1999 were the conversion date. The Series B Stock has
no voting rights. Global owns 100% of the issued and outstanding Series B Stock.
There were 1,500 shares of Series B Convertible Preferred Stock outstanding at
June 30, 2000.
Series C 8% Convertible Preferred Stock ("Series C Stock"); stated value
$1,000 per share and liquidation value of 120% of stated value. The Holder of
Series C Stock is entitled to an annual cumulative dividend of $80 per share
payable quarterly in cash or Common Stock. Each share of Series C Stock is
convertible into Common Stock at a price equal to the lowest of: a) $2.6875 per
share, or b) 66.67% of the Average Price, as defined, or c) at the lowest rate
the Company issues equity securities, as defined. The Series C Stock generally
has no voting rights. On August 24, 1999, Global notified the Company of its
intent to convert such shares into Common Stock contingent upon receiving
shareholder approval to increase the authorized share capital of the Company.
The increase in authorized share capital was subsequently approved at the
September 17, 1999 Special Meeting of the Company's shareholders. Accordingly,
in December 1999, the Company issued 886,000 shares of its Common Stock to
Global upon conversion of all the Series C stock held by Global.
Series D Convertible Preferred Stock ("Series D Stock"); stated value $10
per share and liquidation value of 120% of stated value. The Holder of Series D
Stock is entitled to an annual dividend as and when declared by the Board of
Directors of the Company. The Series D Stock generally has no voting rights. The
Series D Stock is convertible into the Company's Common Stock at a conversion
rate of 6.05 Common shares for each share of Series D Stock.
COMMON STOCK
At June 30, 2000, there are authorized 40,000,000 shares of Common Stock,
par value $0.001 per share. The holders of Common Stock are entitled to one vote
for each share held of record on all matters submitted to a vote of the
shareholders.
On June 1, 2000, the Company executed a master facility agreement with
Fusion Capital Fund II, LLC ("Fusion") pursuant to which Fusion agreed to enter
into an equity purchase agreement with an aggregate available amount of
$12,000,000. Under the master facility agreement, the equity purchase agreement
grants Fusion the right to purchase up to $12,000,000 of the Company's Common
Stock at a price equal to the lesser of (1) $8.00 per share or (2) a price based
on the future performance of the common stock, in each case without any fixed
discount to the market price. Under the agreement, Fusion has the right to
convert up to $1.0 million of the available amount of the purchase equity
agreement each month, plus any prior month amounts that have not yet been
converted, into shares of the Company's Common Stock at the conversion price.
F-20
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
The Company has certain rights to prevent conversion or to require mandatory
conversion. At no time would Fusion be permitted to beneficially own more than
4.99% of the then aggregate outstanding common stock. Additionally, Fusion
received 300,000 shares of the Company's Common Stock as a commitment fee. The
shares were valued at $1,021,860, and $468,183 had been netted against proceeds
received as of June 30, 2000. As of June 30, 2000, Fusion purchased from the
Company an aggregate of 15,400 shares of common stock at an average price of
$3.41 per share and provided an advance, repayable in common shares, of
$448,000.
In December 1999 and January 2000, the Company issued 29,500 and 10,000
shares of common stock respectively, to third parties for investor relation
services to be provided over a twelve month period.
WARRANTS
The following table summarizes warrant activity for the year ended June 30,
2000, the Transition Period ended June 30, 1999 and the year ended October 31,
1998:
Outstanding as of October 31, 1997 --
Issued in connection with consulting services 334,700
Issued in connection with Series B Preferred Stock 162,500
Issued in connection with Series A Notes 189,025
Issued in connection with Series D Notes 70,000
--------------
Outstanding as of October 31, 1998 756,225
Issued in connection with Series E Notes 132,500
Issued in connection with Series F Notes 187,000
Issued in connection with Promissory Notes 290,000
--------------
Outstanding as of June 30, 1999 1,365,725
Issued in connection with consulting services 150,000
Exercised during the year (678,225)
Repurchased during year (64,500)
--------------
Outstanding as of June 30, 2000 773,000
==============
Exercise Price $ 2.41 - 10.00
==============
During the year ended June 30, 2000, the Company issued 150,000 Common
Stock purchase warrants, resulting in 773,000 warrants outstanding at June 30,
2000. Each warrant represents the right to purchase one share of the Company's
Common Stock at exercise prices ranging from $2.41 to $10.00 per share, until
such warrants expire beginning August 12, 2001 through December 23, 2004.
In December 1999, the Company issued common stock purchase warrants to
purchase 25,000 shares of the Company's Common Stock at $6.50 per share to Emden
Consulting Corp. in exchange for advisory services. The exercise period of the
warrants expires in December 2004. Non-cash expense of $144,868 was recorded in
the fiscal year ended June 30, 2000.
In December 1999, the Company issued common stock purchase warrants to
purchase 25,000 shares of the Company's Common Stock at $6.50 per share to
Waterton Group LLC in exchange for advisory services. The exercise period of the
warrants expires in December 2004. Non-cash expense of $144,868 was recorded in
the fiscal year ended June 30, 2000.
In December 1999, the Company issued common stock purchase warrants to
purchase 100,000 shares of the Company's Common Stock at prices ranging from $6
to $10 per share to Continental Capital & Equity Corp. in exchange for public
relations and financial advisory services. The warrants were to vest over a
period of 270 days and expire in February 2002. Non-cash expense of $350,269 was
recorded in the fiscal year ended June 30, 2000.
On March 13, 2000, the Company issued 236,081 shares of its Common Stock in
connection with the cashless exercise of common stock purchase warrants held by
the former holders of the Company's Series A and E notes. The warrants exercised
represented warrants to purchase 311,525 shares of the Company's Common Stock.
F-21
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
Additionally, on March 13, 2000, the Company issued 123,382 shares of its Common
Stock in connection with the cashless exercise of common stock purchase warrants
previously issued in connection with the Company's Series F notes. The warrants
exercised represented warrants to purchase 182,000 shares of the Company's
Common Stock.
In March 2000, the Company repurchased for cash 64,500 Common Stock
purchase warrants for $296,000. The warrants were issued prior to the May 1999
Transaction. The repurchase was recorded as a reduction to additional paid-in
capital.
In May 2000, the Company issued 107,433 shares of its Common Stock in
connection with the cashless exercise of Common Stock purchase warrants issued
in January and May 1998 in connection with financial advisory services. No
services have been provided to the Company since the Transaction Date. The
warrants exercised represented warrants to purchase 184,700 shares of the
Company's Common Stock.
(16) INCOME TAXES
Income taxes (benefit) differed from the amounts computed by applying the
U.S. Federal corporate income tax rate of 34% to net income (loss) as a result
of the following:
<TABLE>
<CAPTION>
TRANSITION
YEAR ENDED PERIOD ENDED YEAR ENDED
JUNE 30, 2000 JUNE 30, 1999 OCTOBER 31, 1998
------------- ------------- ----------------
<S> <C> <C> <C>
Computed expected tax (benefit) $(5,525,746) $ 786,603 $(2,441,415)
Change in federal valuation allowance 3,976,710 (983,188) 2,100,322
Nondeductible expense 1,549,036 16,320 416,498
Other -- 180,265 (75,405)
----------- --------- -----------
$ -- $ -- $ --
=========== ========= ===========
</TABLE>
The tax effects of temporary differences that give rise to significant
portions of the net deferred tax asset are presented below:
TRANSITION PERIOD
YEAR ENDED ENDED
JUNE 30, 2000 JUNE 30, 1999
------------- -------------
Deferred tax assets:
Net operating loss carryforward $ 11,416,005 $ 5,443,825
Property and equipment 1,145,301 972,785
Allowance for bad debts -- 1,517,277
Provision for inventory valuation 3,607,166 3,142,092
Accrued liabilities 876,320 770,859
Deferred revenue -- 146,699
Other -- 262,589
------------ ------------
17,044,792 12,256,126
Less valuation allowance (17,044,792) (12,256,126)
------------ ------------
Net deferred tax asset $ -- $ --
============ ============
In assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred tax
assets will not be realized. The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during the periods in
which those temporary differences become deductible. The Company believes
sufficient uncertainty exists regarding the realization of the tax assets such
that a full valuation allowance is appropriate. As of June 30, 2000, the Company
has a net operating loss (NOL) carryforward for federal income tax purposes of
approximately $28,752,372, which begins to expire in 2009. The Company likely
underwent a change in ownership in accordance with Internal Revenue Code Section
382, the effect of which has not yet been determined by the Company. This change
F-22
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
would effect the timing of the utilization of the NOL, as well as the amount of
the NOL which may ultimately be utilized, though it is not expected to
materially effect the amount of the NOL carryforward.
(17) RELATED PARTY TRANSACTIONS
Prior to the Transaction, TNCi entered into the Promissory Note with Global
in the principal amount of $750,000, bearing interest at a rate of 9.5% per
annum, and a related security agreement granting Global a security interest in
its assets. In July and August 1999, Global purchased all of the Series A and E
notes and the Series D notes issued by TNCi (collectively, the "Series Notes"),
respectively from the holders of such notes. Concurrent with such purchases,
TNCi executed allonges to the Promissory Note, which cancelled the Series Notes
and rolled the principal balance, plus accrued interest, penalties and
redemption premiums of the Series Notes into the principal balance of the
Promissory Note. In August 1999, TNCi executed another allonge to the Promissory
Note which rolled approximately $1.2 million of prior intercompany advances from
Global into the Promissory Note and granted Global the ability to convert the
Promissory Note directly into shares of TNCi's Common Stock as an administrative
convenience. On August 24, 1999, the Board of Directors of Global approved the
conversion of the Promissory Note into approximately 4.8 million shares of
TNCi's Common Stock. Such conversion was contingent upon receiving shareholder
approval to increase the authorized share capital of TNCi. This increase in
authorized share capital was approved on September 17, 1999, and the shares were
subsequently issued in December 1999 based as on the August 24, 1999 conversion
date.
On August 24, 1999, the Company's Board of Directors approved a $5,000,000
secured revolving credit facility by and between TNCi and Global (the
"Facility"). The Facility provides that TNCi may borrow up to $5,000,000 for
working capital and general corporate purposes at the Prime Rate of interest
(9.5% at June 30, 2000) plus 3%. The Facility matures in September 2001. TNCi
paid an origination fee of $50,000 to Global and will pay an unused line fee of
0.5% per annum. The Facility is secured by all of the assets of TNCi and is
convertible into shares of TNCi's Common Stock.
During the year ended June 30, 2000, TNCi had net borrowings of $4.2
million under the Facility. On June 28, 2000 the Board of Directors approved the
conversion of $1,850,000 of the Facility into 1,233,333 shares of TNCi Common
Stock. At June 30, 2000 the balance on the Facility was $2,350,000. During the
year ended June 30, 2000, the Company incurred interest expense of $112,375 to
Global.
TNCi provides certain administrative services to Global, including
accounting, payroll and human resources under an arrangement in which Global
pays TNCi through an intercompany account. Through June 30, 2000, these services
amounted to $175,889. As of June 30, 2000, Global owed to the Company $73,607
which is the net result of various intercompany transactions which includes the
aforementioned charge.
The Company's Chief Executive Officer is a principal of Ocean Castle
Investments, LLC ("Ocean Castle") which maintains administrative offices for the
Company's Chief Executive Officer and certain other employees of Global. During
the year ended October 31, 1998, Ocean Castle executed consulting agreements
with two principal stockholders of Global. The rights and obligations of Ocean
Castle under the agreements were assumed by the Company in connection with the
Transaction. The consulting agreements require payments aggregating $1,000,000
to each of the consultants through December 2003 in exchange for advisory
services. Each of the consultants also received stock options to purchase 50,000
shares of Class A Common Stock of Global at an exercise price of $3.00. As of
June 30, 1999, the Company determined that the consulting agreements had no
future value due to the Company's shift away from in-flight entertainment into
alternative markets such as leisure cruise and passenger rail transport. Only
limited services were provided in 1999, no services were provided in 2000, and
no future services will be utilized. Accordingly, the Company recorded a charge
to general and administrative expenses in the Transition Period of $1.6 million
representing the balance due under such contracts. In August 2000, Global, on
behalf of TNCi, settled the outstanding obligation with the principle
stockholders of Global for Common Stock of Global. The Company will issue to
Global 411,146 shares of its Common Stock as reimbursement to Global for such
settlement.
In May and June 2000, The Gross Charitable Unit Trust and The Gross
Charitable Annuity Trusts (together the "Trusts"), advanced a total of $800,000
to the Company for working capital purposes. An additional $250,000 was advanced
to the Company in July 2000. On September 12, 2000, the advances were converted
into two promissory notes, each in the amount of $525,000, issued to each Trust
F-23
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
by the Company. The notes mature on December 31, 2000 and bear interest at 9%.
The Trusts are controlled by the Company's Chairman and Chief Executive Officer,
Irwin L. Gross.
In August 1999, the Company executed a separation and release agreement
with a shareholder and former officer of the Company, pursuant to which the
Company paid approximately $85,000 in the form of 66,667 unregistered shares of
the Company's common stock.
In June 1999, the Company loaned to a vice president, $75,000 for the
purpose of assisting in a corporate relocation to the Company's headquarters in
Phoenix, Arizona. The Company also added other outstanding advances to the
principal amount of the rate in the amount of $42,000. Such loan is secured by
assets of the employee. The note matures in August 2009 and bears an interest
rate of approximately 5%.
Global had an Intellectual Property License and Support Services Agreement
(the "License Agreement") for certain technology with FortuNet, Inc.
("FortuNet"). FortuNet is owned by a principal stockholder and former director
of Global. The License Agreement provides for an annual license fee of $100,000
commencing in October 1994 and continuing through November 2002. The Company
paid FortuNet $100,000 during each of the years ended October 31, 1998 and 1997.
As of October 31, 1998, the remaining commitment of $400,000 is included in
accrued liabilities on the balance sheet. The Company assumed this liability in
connection with the Transaction. In September 1999, the Company agreed to a
termination of this agreement and paid FortuNet $100,000 plus legal fees. During
the Transition Period ended June 30, 1999, the Company had revised its estimated
accrual to $200,000 which is included in accrued liabilities at June 30, 1999.
During the year ended June 30, 2000, actual costs associated with this
settlement were $43,150 less than the estimate. Accordingly, the Company
reversed the liability and reduced administrative expense.
During the year ended October 31, 1998, Global extended by one year a
consulting agreement with a former officer of Global pursuant to which Global
will pay $55,000 for services received during the period November 1999 through
October 2000. The Company assumed the liability for the consulting agreement in
connection with the Transaction in the amount of $55,000 which is included in
accrued liabilities at June 30, 1999. As of June 30, 2000, $18,000 remained to
be paid.
During the year ended October 31, 1998, Global executed severance and
consulting agreements with three former officers, pursuant to which Global paid
the former officers and set aside restricted funds in the amounts of $3,053,642
and $735,000, respectively. The consulting agreements all expired by September
1999. Payments totaling $735,000 were made from restricted cash of Global
through September 1999. Expenses associated with these agreements were charged
to general and administrative expenses in the year ended October 31, 1998.
During the year ended October 31, 1996, Global executed severance
agreements with three former officers pursuant to which the Company will pay
severance of $752,500 over a three-year period. As of June 30, 2000 and 1999,
zero and $18,000 remained to be paid under these agreements. Such liabilities
were assumed by the Company in connection with the Transaction.
The Company has agreed to reimburse B.H.G. Flight, LLC ("BHG") for costs
and expenses associated with the Company's use for corporate purposes of an
airplane owned by BHG. Irwin L. Gross, Chairman of the Board and Chief Executive
Officer, owns a 50% interest in BHG. To date, the Company has incurred
approximately $44,000 for such costs and expenses.
(18) COMMITMENTS AND CONTINGENCIES
(a) LITIGATION
Swissair/MDL-1269, IN REGARDS TO AN AIR CRASH NEAR PEGGY'S COVE, NOVA
SCOTIA. This multi-district litigation, which is being overseen by the United
States District Court for the Eastern Division of Pennsylvania, relates to the
crash of Swissair Flight No. 111 on September 2, 1998. The Swissair MD-11
aircraft involved in the crash was equipped with an entertainment network system
that had been sold to Swissair by Global's predecessor company, Interactive
F-24
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
Flight Technologies, Inc. Estates of the victims of the crash have filed
lawsuits throughout the United States against Swissair, Boeing, Dupont and
various other parties, including Global and TNCi, which has been named in some
of the lawsuits filed on a successor liability theory. TNCi and Global deny all
liability for the crash. TNCi and Global are being defended by our aviation
insurer.
On September 1, 1999, SAir Group invited the Company to participate in a
conciliation hearing before the Justice of the Peace in Kloten, Switzerland,
which is the customary manner in which civil litigation is initiated in
Switzerland. The document informing us of the proceeding states that the request
has been filed in connection with the crash of Swissair Flight 111 primarily in
order to avoid the expiration of any applicable statutes of limitations and to
reserve the right to pursue further claims. The document states that the relief
sought is "possibly the equivalent of CHF 342,000,000 - in a currency to be
designated by the court; each plus 5% interest with effect from September 3,
1998; legal costs and a participation to the legal fees (of the plaintiff) to be
paid by the defendant."
BRYAN R. CARR V. THE NETWORK CONNECTION, INC. AND GLOBAL TECHNOLOGIES,
LTD., Superior Court of Georgia, Civil Action No. 99-CV-1307. Bryan R. Carr,
TNCi's former Chief Operating and Financial Officer and a former Director, filed
a claim on November 24, 1999 alleging a breach of his employment agreement with
TNCi. Mr. Carr claims that he is entitled to the present value of his base
salary through October 31, 2001, a share of any "bonus pool," the value of his
stock options and accrued vacation time. TNCi and we filed a motion to compel
arbitration of the claims pursuant to an arbitration provision in the employment
agreement and to stay the State Court action pending the arbitration proceeding.
The Company's motion was granted on August 9, 2000. As of this date, Mr. Carr
has not filed an arbitration claim against TNCi or Global, but on September 20,
2000, Mr. Carr sent a letter to the Company stating his demands in hopes of
settlement.
A suit captioned AVNET, INC. V. THE NETWORK CONNECTION, INC., was filed May
17, 2000 in Maricopa County Superior Court, CV2000-009416. The suit relates to
invoices for inventory purchased by TNCi in late 1998 and early 1999. Avnet,
Inc. seeks payment of the invoices, interest and legal fees. TNCi has not paid
for the inventory purchased primarily for the following reasons: (i) the
inventory purchased did not meet specifications and thus was not accepted by
TNCi's customer, and (ii) TNCi is currently pursuing a separate warranty claim
against Avnet regarding certain other inventory purchased from Avnet.
The Company is subject to other lawsuits and claims arising in the ordinary
course of its business. In the Company's opinion, as of June 30, 2000, the
effect of such matters will not have a material adverse effect on the Company's
results of operations and financial position.
(b) LEASE OBLIGATIONS
The Company leases office space and equipment under operating leases which
expire at various dates through August 2005. The future minimum lease
commitments under these leases are as follows:
YEARS ENDING JUNE 30, TOTAL
--------------------- -----------
2001 $ 566,689
2002 626,215
2003 519,362
2004 519,362
2005 502,721
-----------
Total minimum lease payments $ 2,734,349
===========
F-25
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
Rental expense under operating leases totaled $175,042, $292,042 and
$944,932 for the fiscal year ended June 30, 2000, for the Transition Period
ended June 30, 1999 and the fiscal year ended October 31, 1998 , respectively.
(19) SPECIAL CHARGES AND REVERSAL OF WARRANTY, MAINTENANCE AND COMMISSION
ACCRUALS
Global had previously entered into sales contracts with three airlines,
Schweizerische Luftverkehr AG ("Swissair"), Debonair Airways, Ltd. ("Debonair")
and Alitalia Airlines, S.p.A. ("Alitalia") for the manufacture and installation
of its in-flight entertainment network, and to provide hardware and software
upgrades, as defined in the agreements. In connection with the Transaction, the
Company assumed all rights and obligations of the above contracts.
Pursuant to the October 1997 agreement with Swissair, Swissair purchased
shipsets for the first and business class sections of sixteen aircraft for an
average of $1.7 million per aircraft. Included in the purchase price was
material, installation, maintenance through September 1998, one-year warranty
and upgrade costs for the sixteen aircraft. As of October 31, 1998, the Company
had completed installations of the entertainment network on all of these
aircraft. The agreement also required the Company to install the entertainment
network in the first, business and economy class sections of three additional
aircraft, at no charge to Swissair. The Company was responsible for all costs
including entertainment network components, installation and maintenance through
September 1998 for the three aircraft. As of October 31, 1998, the Company had
completed installations of the entertainment network on all of these aircraft
and title to each of these three shipsets had been transferred to Swissair.
During the fiscal year ended October 31, 1998, the Company recognized a recovery
of special charges of $606,508 which resulted from a reduction in the number of
entertainment networks requiring maintenance in the economy class sections of
the Swissair aircraft and a reduction in development expenses.
In April 1998 and October 1998, the Company entered into additional
contracts with Swissair. The first letter of intent related to a $4.7 million
order for first and business class installations on four Swissair MD-11 aircraft
that were being added to the Swissair fleet. Swissair had made payments of
$1,450,000 on the $4.7 million order through February 1999. No payments have
been received since February. The second contract was to extend the warranty on
all installed systems for a second and third year at a price of $3,975,000.
Through February 1999, the Company had been paid $707,500 under this contract.
No subsequent payments have been received from Swissair.
On October 29, 1998, the Company was notified by Swissair of its decision
to deactivate the entertainment networks on all Swissair aircraft. However, by
April 1999, discussions between the Company and Swissair regarding outstanding
financial matters related to current accounts receivable, inventory, purchase
commitments and extended warranty obligations, as well as planning discussions
for an October 1999 reactivation ceased to be productive. On May 6, 1999, Global
filed a lawsuit against Swissair in the United States District Court for the
District of Arizona seeking damages for Swissair's failure to honor its
obligations for payment and reactivation of the Company's Entertainment Network.
The Swissair agreements are not assignable to third parties under the terms
of such agreements. However, in connection with the Transaction, Global has
agreed to pay to the Company any net proceeds, if any, received from Swissair as
a result of the above litigation or otherwise. Further, the Company, as a
subcontractor to Global, will assume any operational responsibilities of the
Swissair agreement in the event that such requirement arises. The Company has
not assumed any liabilities or obligations arising out of the crash of Swissair
Flight No. 111.
As a result of the above events, management concluded that its only source
of future payment, if any, will be through the litigation process. In addition,
with the deactivation of the entertainment system and Swissair's breach of its
agreements with Global, the Company believes it will not be called upon by
Swissair to perform any ongoing warranty, maintenance or development services.
Swissair's actions have rendered the Company's accounts receivable, inventory
and deposits worthless as of June 30, 1999. Accordingly, for the Transition
Period, the Company has recognized revenue on equipment sales to the extent of
cash received of $876,000; charged off inventory to cost of equipment sales in
the amount of $1,517,000; wrote off deposits of $655,000 to special charges; and
reversed all warranty and maintenance accruals totaling $5,164,000.
F-26
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
Pursuant to an agreement with Debonair, the Company was to manufacture,
install, operate, and maintain the entertainment network on six Debonair
aircraft for a period of eight years from installation. In February 1998, the
Company and Debonair signed a Termination Agreement. Pursuant to the Termination
Agreement, Debonair removed the entertainment network from its aircraft and the
Company paid Debonair $134,235 as full and final settlement of all of its
obligations with Debonair.
In connection with these agreements with Swissair and Debonair and the
absence of any new entertainment network orders, the Company recorded property
and equipment write-downs of $1,006,532 during fiscal 1998, which are included
in special charges on the consolidated statement of operations.
Pursuant to an agreement with Alitalia, the Company delivered five first
generation shipsets for installation on Alitalia aircraft during fiscal 1996.
Subsequently, Alitalia notified the Company that it did not intend to continue
operation of the shipsets, and the Company indicated that it will not support
the shipsets.
For the Transition Period ended June 30, 1999, the Company recorded
warranty, maintenance and commission accrual adjustments of $5,117,704,
$1,730,368 and $303,321, respectively, related to the Swissair and Alitalia
matters. Such adjustments to prior period estimates, which totaled $7,151,393
resulted from an evaluation of specific contractual obligations and discussions
between the new management of the Company and other parties related to such
contracts. Based on the results of the Company's findings during this period,
such accruals were no longer considered necessary.
(20) SEGMENT INFORMATION
The Company operates principally in one industry segment; development,
manufacturing and marketing of computer-based entertainment and data networks.
Prior to the Transition Period, the Company's principal revenues had been
derived from European customers. Since the Transaction, the majority of revenues
have been derived from the sale of servers and equipment in the U.S.
For the year ended June 30, 2000, one customer accounted for 78% of the
Company's sales. For the Transition Period ended June 30, 1999 and the year
ended October 31, 1998, one different customer accounted for 91% and 98% of the
Company's sales, respectively. Outstanding receivables from each of the
customers were zero at June 30, 2000 and June 30, 1999.
(21) SUPPLEMENTAL FINANCIAL INFORMATION
Supplemental disclosure of cash flow information is as follows:
<TABLE>
<CAPTION>
YEAR ENDED TRANSITION YEAR ENDED
JUNE 30, PERIOD ENDED OCTOBER 31,
2000 JUNE 30, 1999 1998
----------- ------------- -----------
<S> <C> <C> <C>
Cash paid for interest $ 28,777 $ -- $ 11,954
=========== ==== ========
Non-cash for investing and financing activities:
Issuance of warrants and stock to third parties
for services and in connection with financing $ 1,166,880 $ -- $ --
Issuance of warrants to related party for
collateral pledges 797,668 -- --
Conversion of Promissory Note 4,476,048 -- --
Conversion of note payable 400,000 -- --
Beneficial conversion on Facility 4,200,000 -- --
Partial conversion of Facility 1,850,000 -- --
Net Issuance of commitment shares associated with
equity purchase agreement 553,677 -- --
</TABLE>
(22) SUBSEQUENT EVENTS
(a) CONVERSION OF SERIES D PREFERRED STOCK
On August 2, 2000, upon receipt of notice of conversion from Global, the
Company issued 5,000,000 shares of its Common Stock to Global upon conversion of
826,447 shares of the Company's Series D Preferred Stock held by Global. As of
September 25, 2000, Global's ownership in the Company was 77% on an if-converted
common stock basis.
F-27
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
(b) ISSUANCE OF SERIES E CONVERTIBLE PREFERRED STOCK
In August 2000, the Company designated 500 shares of Series E 6%
Convertible Preferred Stock ("Series E Stock"); stated value $10,000 per share
and liquidation value $10,000 per share plus accrued and unpaid dividends. At
the option of the Holder, beginning 180 days after the date of issue, each share
of Series E Stock is convertible into common stock at the lesser of $4.00 per
share or the Average Market Price for common stock for the five consecutive
trading days immediately preceding such date, as defined. The Company may redeem
the Series E Stock at prices ranging from 110% to 120% of stated value, plus
accrued dividends during the first 180 days from date of issue. The redemption
premium increases at a rate of 3% per month to a maximum of 140% of stated
value.
On August 3, 2000, the Company entered into a subscription agreement for
the sale of up to 500 shares of Series E Stock. On that date, the Company sold
for net proceeds of approximately $920,000, 100 shares of its Series E Stock.
(c) ISSUANCE OF NOTE PAYABLE AND WARRANTS
On September 12, 2000, the Board of Directors authorized the issuance of
common stock purchase warrants to purchase 311,560 shares of the Company's
Common Stock which have been divided equally between two trusts controlled by
Irwin L. Gross, the Chairman and Chief Executive Officer of the Company, as
compensation for various working capital advances made to the Company from May
2000 through July 2000. As of June 30, 2000, advances totaled $800,000 and
additional advances of $250,000 have been made subsequent to year end. On
September 12, 2000, the Company's Board of Directors also approved the
conversion of these advances into promissory notes from the Company. (See Note
10). The number of warrants issued for each advance was based upon the amount
advanced divided by the closing market price of the Company's common stock on
the date of each advance. The warrants have an exercise price based upon the
closing market price of the Company's Common Stock on the date of the advance
and a term of five years from such date. The fair value of the warrants issued
were $797,000 of which $137,000 was recorded as a non-cash charge to interest
expense in the year ended June 30, 2000.
(d) INVESTMENT BY OFFICER
In August 2000, an officer of the Company advanced $970,000 to the Company
for working capital purposes in exchange for common stock. Final terms and
conditions of this investment have not been reached, however, common stock
purchase warrants of the Company will be issued in connection with this
transaction.
(e) CARNIVAL AGREEMENT
In September 1998, the Company entered into a Turnkey Agreement (the
"Carnival Agreement") with Carnival Corporation ("Carnival") for the purchase,
installation and maintenance of its advanced cabin entertainment and management
system for the cruise industry ("CruiseView(TM)") on a minimum of one Carnival
Cruise Lines ship. During the four-year period commencing on the date of the
Carnival Agreement, Carnival had the right to designate an unspecified number of
additional ships for the installation of CruiseView(TM). The cost per cabin for
CruiseView(TM) purchase and installation on each ship was provided for in the
Carnival Agreement. In December 1998, Carnival ordered the installation of
CruiseView(TM) on one Carnival Cruise Lines "Fantasy" class ship which has been
in operational use since August 1999. In August 1999, Carnival ordered the
installation of CruiseView(TM) on one Carnival Cruise Lines "Destiny" class ship
which was in operational use from October 1999 through March 2000. Under the
terms of the agreement, the Company was to receive payment for 50% of the sales
price of the system in installments through commencement of operation of the
system. Recovery of the remaining sales price of the system was to be achieved
through the receipt of the Company's 50% share of net profits, as defined in the
Carnival Agreement, generated by the system over future periods.
F-28
<PAGE>
THE NETWORK CONNECTION, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
The terms of the Carnival Agreement provided that Carnival may return the
CruiseView(TM) system within the acceptance period, as defined in the Carnival
Agreement, or for breach of warranty. The acceptance period for the Fantasy and
Destiny class ships were twelve months and three months, respectively, from
completion of installation and testing, which occurred in February 1999 and
October 1999, respectively. The initial warranty period for these systems was
three years. As of March 31, 2000, the Company had recorded deferred revenue of
approximately $2.1 million related to the two Carnival ships.
Beginning in the quarter ended March 31, 2000, the Company had experienced
costs in excess of those recoverable under the Carnival Agreement. Given these
costs, and ongoing technical issues, the Company notified Carnival of its desire
to renegotiate the Carnival Agreement. During these discussions, Carnival
notified the Company in a letter dated April 24, 2000 that it sought to
terminate the Carnival Agreement and sought to assert certain remedies
thereunder. On September 25, 2000, the Company entered into a Master Settlement
Agreement and Mutual Release with Carnival (the "Settlement Agreement"). The
Settlement Agreement specifies that the Company and Carnival agree: (i) To
terminate the Carnival Agreement; (ii) to negotiate in good faith to enter into
a New Agreement; (iii) that the Company will issue to Carnival a one-year
convertible note payable in the principal amount of $550,000; (iv) to mutually
release each party from any prior claims; and (v) the Company shall retain
ownership of any and all equipment (other than wiring and switching equipment
installed for networking purposes which Carnival purchased and paid in full
pursuant to the Carnival Agreement) installed on any Carnival ship.
Based on the above, the Company recorded revenue of $1.4 million for the
value of networking equipment purchased by Carnival, cost of revenue in an equal
amount by applying the cost recovery method of accounting and special charges of
approximately $2.1 million resulting from the Settlement Agreement. The Company
also recorded a special charge reflecting the write-off of: (i) all remaining
inventory associated with Carnival as substantial uncertainty exists regarding
its realizability (approximately $2.1 million); (ii) all costs associated with
the deinstallation and removal of equipment from the two ships (approximately
$85,000) and (iii) all costs associated with the refurbishment of certain
equipment such that the equipment may be re-deployed to other customers
($174,000). Special charges were offset by the reversal of deferred revenue of
$190,000 which the Company was not required to return to Carnival, and warranty
accruals for which the Company has no continuing obligation.
Pursuant to the Settlement Agreement, the Company and Carnival continued
discussions with respect to a New Agreement which would cover the installation
of the Company's latest CruiseView(TM) technology on the "Fantasy" class ship
discussed above, and contractual terms more favorable to the Company than the
Carnival Agreement, including a longer-term and multiple ship arrangement. The
Company believes its new technology improves the Company's ability to create
multiple new content and commerce-based revenue streams, and to establish a
business relationship providing appropriate returns to each partner. However,
while the Company is optimistic about the discussions, there is no assurance
that the Company will be successful in reaching a mutually satisfactory
resolution of the Carnival Agreement and in securing a new, more favorable
long-term contract with Carnival. Notwithstanding the above, the Company
continues to operate its CruiseView(TM) system aboard one Carnival Fantasy class
ship on a month-to-month basis and will continue to do so as long as the
economics are beneficial to the Company and Carnival.
F-29
